Investors in the financial markets are increasingly convinced that the Federal Reserve will soon lower interest rates. However, analysts caution that the timing of such a move could potentially disrupt the markets.
According to research conducted by Ned Davis Research, a historical analysis of the yield on the 10-year Treasury note (BX:TMUBMUSD10Y) provides valuable insights into the behavior of the market before the first rate cut of a Federal Reserve easing cycle. The data, spanning back to 1970, reveals a consistent trend.
Three months prior to the expected rate cut in March, which is widely anticipated to reduce rates by a quarter-point, the yield on the 10-year note stood at 3.95%. The table showcases a pattern where yields have consistently declined leading up to the initial rate cut during every easing cycle studied. On average, yields have fallen by 90 basis points, or 0.9 percentage point. This decline in yields corresponds with an increase in Treasury prices.
Joe Kalish, Chief Global Macro Strategist at Ned Davis Research, suggests that even applying the minimum decline of 38 basis points seen in 1981 would result in a yield of 3.57%. Kalish points out that "a few weak economic reports" could easily lead to such a decline.
In contrast to the performance of yields, the stock market has exhibited relatively flat performance in the three-month period preceding the initial rate cut. Kalish notes that stocks have never rallied more than 11% during this period and, as of Wednesday's closing, the S&P 500 had only gained 0.1% since December 20.
However, after the first rate cut takes place, stocks tend to rally over the next six to seven months. Based on historical data, Kalish states that the S&P 500 typically records an average gain of 12% during this period. Over the entire easing cycle, stocks have seen a mean rise of around 21% and a median rise of 15.4%. It is worth noting that the S&P 500 has rallied during every easing cycle since 1970, except for a significant 27.6% drop following the collapse of the tech bubble between January 3, 2001, and June 25, 2003.
In summary, investors anticipate an upcoming rate cut from the Federal Reserve. The historical performance of yields and stocks before and after the initial rate cut provides intriguing insights. Market participants will closely monitor economic reports in the coming months to assess the potential impact on yields and stock market performance.
Fed Officials Consider Holding Benchmark Rate Steady for Longer
In a recent meeting, the Federal Reserve discussed the possibility of keeping the benchmark interest rates unchanged for a longer period than initially expected. Although a further rate hike has not been completely ruled out, the Fed has maintained the fed-funds rate at a range of 5.25% to 5.5% since July.
According to the minutes of the Dec. 12-13 meeting, a few officials acknowledged the need to extend the duration of steady rates beyond their original projections. Conversely, some officials advocated for a reduction in rates.
The market reacted to the release of the minutes with a decreased expectation of a rate cut in March. Fed-funds futures traders, as measured by the CME FedWatch tool, currently assign a 66.4% probability for at least a quarter-point decrease by March 20. This is a decline from nearly 87% a week earlier.
The traders' projections for rate cuts throughout 2024 show a nearly 60% probability of six quarter-point reductions, contrasting with the three reductions predicted in the Fed's dot-plot projections.
While historical data suggests that Treasury prices would typically rise if a March rate cut was on the horizon, the timing of the cut could affect this trend. Economist Kalish advised caution, highlighting that if the rate cut were to be pushed back to May or June, Treasury yields may not respond as positively.
Additionally, both stocks and Treasurys experienced a pullback after ending 2023 on a strong note. Investors are questioning the aggressive pace of rate cuts priced into the market. Kalish emphasized that six cuts would suggest a more challenging economic environment, contrary to the "Goldilocks-like" soft landing theory that justified the market rally in 2023.
Considering these factors, it becomes clear that the timing and number of rate cuts remain uncertain. While vigilance is necessary, it is crucial to remember that the Fed is evaluating various options to maintain a balanced economic landscape.
