The U.S. Federal Reserve (Fed) reduced its target policy rate (“fed funds rate”) range by 0.25 percent today following its two-day meeting. The move was widely expected after a clear shift in messaging from the Fed’s prior meeting and recent speeches. Fed Chairman Jerome Powell indicated some reservations around multiple additional cuts, which markets are currently pricing in, though left the door open for additional rate cuts if warranted. Insurance against global economic weakening and muted inflation pressures were cited as reasons for today’s rate reduction. Market expectations for future cuts fell slightly, but still indicate reasonably high odds of two additional 0.25 percent cuts this year and one cut next year. Stocks fell on the news that Chairman Powell didn’t more forcefully endorse additional rate cuts. Investment performance across asset classes following initial rate cuts has varied historically, depending on whether the rate cuts were pre-emptive in nature or whether they were in response to significant economic deterioration. We continue to monitor the Fed and high frequency economic data.
Markets focused on the formal statement and Chairman Powell’s press conference, as the Fed provided no updates to economic projection documents at this meeting and a rate cut of 0.25 percent was already priced in. Chairman Powell stated that despite the strong U.S. labor market and domestic economic activity that has risen at a moderate rate, today’s rate cut “is intended to insure against downside risks from weak global growth and trade policy uncertainty, to help offset the effects these factors are having on the economy, and to promote a faster return of inflation to our 2 percent objective,” The Fed also announced an immediate halt to its balance sheet runoff, which had originally been scheduled for September. This indicates the Fed will continue to hold a large portfolio of assets for the foreseeable future and should be viewed as further modest stimulus, albeit expected. Importantly, Powell referred to today’s cut as a “mid-cycle adjustment to policy,” in contrast to a lengthy interest rate cutting cycle, dampening market hopes for aggressive future rate cuts. He later clarified he did not intend to imply this cut was “one and done.” Two voting members favored keeping the policy rate unchanged.
Short-term Treasury yields rose (prices fell), with the 2-year yield rising to around 1.87 percent, while 10-year Treasury yields fell slightly to 2.01 percent. Riskier assets, such as domestic and international stocks, fell between 0.50 to 1.25 percent, while high yield bonds and real estate investment trusts (REITs) were down close to 0.25 percent on the day. The U.S. dollar rallied around 0.30 percent. A seeming lack of commitment from Chairman Powell that further rate cuts are imminent triggered weak asset performance following the meeting. Fed communication remains disconnected with markets pricing three more rate cuts this year and next. Despite today’s reaction, investor sentiment remains strong, indicating that investors are maintaining high expectations for multiple rate cuts to prevent significant economic weakening in the U.S. This creates a potentially volatile market environment if the Fed does not deliver interest rate cuts in line with market expectations or if the economic outlook deteriorates significantly.
Investment performance varies after initial rate cuts
Our historical analysis indicates rate cuts can result in divergent investment performance depending on the type of environment. One scenario tends to occur when rate cuts result from the Fed taking pre-emptive but limited measures to ward off slowing economic data, followed by a steady fed funds rate or even a resumption in rate hikes (an “insurance” cut). Riskier assets like stocks tend to perform quite well and bonds underperform in these instances. However, when rate cuts coincide with further economic weakness, resulting in more aggressive ongoing rate cuts (a rate cut cycle), stocks often perform poorly, and lower risk bonds perform well.
The graph below displays historical total returns for stocks and bonds split by various rate cut regimes since 1984. We refer to an “insurance” cut as a rate reduction of 1.00 percent or less, whereas a “rate cut cycle” refers to a series of fed funds rate cuts that well-exceeds 1.00 percent, with total cuts falling anywhere from approximately 2.00 to 5.00 percent. It is apparent that insurance cuts have preceded periods of strong stock returns and normal bond returns, while rate cut cycles more often preceded periods of weak stock returns and strong bond returns.
Rate cut cycles
|Large cap stocks||11.0%||11.2%||19.8%||2.0%|
|Investment grade bonds||6.8%||8.3%||6.1%||11.0%|
Source: U.S. Bank Wealth Management, 1/1/1984-6/30/2019. Large cap stocks represented by the S&P price return of the S&P 500 from 12/31/1983-12/31/1987 and the S&P 500 total return index from 1/1/1988-6/30/2019. Investment grade bonds represented by the total return of the Bloomberg Barclays U.S. Aggregate index.
It is premature to determine whether today’s 0.25 percent reduction to the Fed’s target funds rate is the beginning of an aggressive rate cut cycle that will coincide with material economic weakness or if economic data will stabilize to the extent a smaller number of cuts will suffice. Markets are currently anticipating rate cuts that fall into the “insurance” category based on market-implied pricing in rate markets, as well as somewhat elevated valuations in most segments of the stock and bond markets.
We remain focused on the trend in economic data in the United States and globally. We track hundreds of economic data points across the globe via our proprietary “Health Check” monitor, which indicates the global economy is on a path of a re-synchronized slowdown. The rest of the world is slowing and the U.S. economy, which had been outperforming, is now moving back in line with the rest of the world. However, odds of a recession, while rising, remain modest globally and subdued for the United States. In short, we anticipate economic weakness to persist, but will not represent cycle-ending economic weakness.
As a result, we are maintaining our balanced assessment of risks between stocks and bonds, which is guiding our recommendation to hold stock and bond allocations close to long-term strategic target allocations. This reflects higher levels of volatility across global equity markets and lower bond yields in the United States relative to year-ago levels. Overall, we advise that bond portfolios be primarily comprised of high-quality bonds, to provide adequate portfolio diversification against riskier portfolio allocations.
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Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer's ability to make principal and interest payments. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults).
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