Investors are eagerly anticipating a potentially historic round of interest rate cuts by the Federal Reserve, despite the absence of a recession in the current economy. Nicholas Colas of DataTrek Research warns investors to review their expectations and consider the potential consequences.
Federal Reserve Policy and Investor Expectations
While the Fed’s Summary of Economic Projections only projects three quarter-point rate cuts in 2024, fed-funds futures traders are pricing in a more aggressive estimate of five to six rate cuts by the end of this year. This divergence is attributed to economists’ belief that the Fed will maintain real interest rates at a steady level if inflation continues to decline.
Tying Aggressive Rate-Cut Pricing to Economic Trends
The expectation of aggressive rate cuts is largely influenced by the anticipation that the Fed will keep real interest rates stable even as inflation decreases. The current consensus predicts that the fed-funds rate will remain between 5.25% and 5.50% following the upcoming two-day policy meeting.
Stocks at All-Time Highs
Meanwhile, stock markets have reached new highs, as evidenced by the S&P 500 and Dow Jones Industrial Average achieving their sixth record close in 2024 on Monday.
Historical Perspective on Rate Cuts
DataTrek Research analyzed past easing cycles to assess market expectations for a decline of at least 1.25 percentage points within a year. They found that these conditions aligned with past easing cycles only once in the last four decades, specifically in 1985-86, when a recession was not anticipated. During this period, the Fed reduced the fed-funds rate from 11.6% to 5.9%, leading to a significant rally in the stock market.
In conclusion, investors’ optimism surrounding aggressive rate cuts by the Federal Reserve stems from their belief that it will support economic growth and stability. However, it is crucial to consider historical precedents and the potential divergence from the Fed’s projections.
Market History Revisited: Lessons from Black Monday
Students of market history are undoubtedly familiar with the iconic events that unfolded on Black Monday, October 19, 1987. The S&P 500 experienced an unprecedented plunge of over 20% in just one day, while the Dow plummeted by 23%. As a result, the S&P 500 concluded the fourth quarter of 1987 with a loss of 23%.
Drawing parallels to the past, market experts are now closely observing the Federal Reserve’s response to present-day economic conditions. In light of the cautionary tale of the late 1980s, the Fed is treading carefully, especially given the current lower absolute policy rates. This increased sense of caution has led to doubts about the pace of rate cuts anticipated for 2024.
Experts like Colas warn that prematurely initiating substantial rate cuts can result in an unsustainable rally, akin to what occurred in 1987. The stock market’s remarkable performance thus far also adds to concerns about potential hazards on this course.
While acknowledging the potential insights conveyed by fed-funds futures traders, Colas remains skeptical about their impact on signaling an economic downturn. The current market expectations may be driven by an anticipation that the Fed will adopt a less restrictive stance as inflation continues to decline. However, Colas emphasizes that this perspective fails to align with historical data or the institutional memory of the Federal Reserve.
The seeming contradictions between various market indicators have indeed generated significant attention. Deutsche Bank strategists have observed that substantial rate cuts, like those factored in by the market, have typically coincided with periods of recession. Notably, the mid-1980s episode followed a period of rate hikes by the Paul Volcker-led Fed to curb inflation.
As stock-market bulls eagerly await Federal Reserve rate cuts, it is essential to approach this prospect with caution. History offers valuable lessons, urging restraint and prudence in the face of economic uncertainties.