A topic I’ve noticed that is buzzing among financial market participants lately is what would happen to the US stock market if and when the Federal Reserve, the US’s central bank, cuts interest rates later this year.
There is a high likelihood of a rate cut coming, although there is more uncertainty around the timing and the extent of any cut. In a speech last week, the central bank’s chair, Jerome Powell, said (emphases are mine):
“The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
I have no crystal ball, but I do have historical context. Josh Brown, CEO of Ritholtz Wealth Management, a US-based investment firm, recently shared fantastic data on how US stocks have performed in the past when the Federal Reserve lowered rates. His data, in the form of a chart, goes back to 1957 and I reproduced them in tabular format in Table 1; it shows how US stocks did in the next 12 months following a rate cut, as well as whether a recession occurred in the same window:
I also split the data in Table 1 according to whether a recession had occurred shortly after a rate cut, since eight of the 21 past rate-cut cycles from the Federal Reserve since 1957 took place without an impending recession. Table 2 shows the same data as Table 1 but for rate cuts with a recession; Table 3 is for rate cuts without a recession.
With all the data found in Tables 1, 2, and 3, here are my takeaways:
- US stocks have historically done well, on average, in the 12 months following a rate-cut. The overall record, seen in Table 1, is an average 12-month forward return of 9%. When a recession happened shortly after a rate-cut, the average 12-month forward return is 8%; when a recession did not happen shortly after a rate-cut, the average 12-month forward return is 12%.
- Drawdowns – the maximum peak-to-trough decline in stocks over a given time period – have occurred nearly all the time following a rate-cut. This is not surprising. It’s a feature of the stock market that you would often have to endure a sharp shorter-term fall in stock prices in order to earn a positive longer-term return.
- A recession is not necessarily bad for stocks. As Table 2 shows, US stocks have historically delivered an average return of 8% over the next 12 months after rate cuts that came with impending recessions.
- It’s not a guarantee that stocks will produce good returns in the 12 months after a rate cut even if a recession does not occur, as can be seen from the August 1976 episode in Table 3.
- My most important takeaway is that a rate-cut is not guaranteed to be a good or bad event for stocks. One-factor analysis in the financial markets – “if A happens, then B will occur” – should be largely avoided because clear-cut relationships are rarely seen.
It’s worth bearing in mind that it’s not a certainty that the Federal Reserve will be cutting rates in the near future. Anything can happen in the financial markets. And even if a rate cut does happen, no one knows for sure how the US stock market would perform. History is not a perfect indicator of the future and the best it can do is to give us context for the upcoming possibilities.
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