As Fed cuts loom, health of US economy could determine markets' path

By Lewis Krauskopf, Prinz Magtulis, Pasit Kongkunakornkul and Vineet Sachdev

NEW YORK (Reuters) -How stocks, bonds and the dollar perform after the Federal Reserve kicks off its rate-cutting cycle could depend on one factor more than most: the health of the U.S. economy.

The Fed is expected to kick off a series of rate cuts on Wednesday, after raising borrowing costs to their highest level in nearly two decades. Markets are pricing in roughly 250 basis points of easing by the end of 2025, LSEG data showed.

For investors, a key question may be whether the Fed will cut rates in time to avert a potential economic slowdown.

The S&P 500 has slumped an average of 4% in the six months following the first reduction of a rate-cutting cycle, if the economy was in a recession, data from Evercore ISI going back to 1970 showed. That compares to a 14% gain for the S&P 500 when the Fed cut in a non-recessionary period. The index is up 18% in 2024.

“If the economy is falling into recession, the rate cuts aren’t enough of a support to offset the move down in corporate profits and the high degree of uncertainty and lack of confidence,” said Keith Lerner, co-chief investment officer at Truist Advisory Services.

Treasuries have performed better during recessions, as investors seek the safety of U.S. government bonds. The dollar, meanwhile, tends to rise less during a downturn, though its performance could depend on how the U.S. economy fares in comparison with others.

STOCKS

Recessions are typically called in hindsight by the National Bureau of Economic Research and for now, economists see little evidence that the U.S. is currently experiencing one.

Those conditions bode well for the rally in U.S. stocks, should they persist.

“Based on previous easing cycles, our expectation for aggressive rate cuts and no recession would be consistent with strong returns from U.S. equities,” said James Reilly, senior market analyst at Capital Economics, in a report.

Still, worries over the economy have jolted asset prices in recent weeks.

Weakness in the U.S. labor market has helped fuel sharp swings in the S&P 500, while global growth concerns are reflected in slumping commodity prices, with Brent crude oil trading near its lowest level since late 2021.

Uncertainty over whether growth is merely falling back to its long-term trend or showing signs of a more serious slowdown are reflected in futures markets, which in recent days have swung between pricing in a 25- or 50-basis-point cut on Wednesday.

The state of the economy is important for investors looking to gauge stock performance over the longer term, as well. The S&P 500 was down an average of nearly 12% one year after an initial cut that took place during a recession, according to a study by Ryan Detrick, chief market strategist at Carson Group.

That compares to an average gain of 13% following cuts that came in a non-recessionary period, when the reductions were to “normalize” policy, according to the data, which studies the last 10 easing cycles.

“The linchpin to the whole thing is that the economy avoids recession,” said Michael Arone, chief investment strategist for State Street (NYSE:STT ) Global Advisors.

Overall, the S&P 500 has been 6.6% higher a year after the first rate cut of a cycle — about a percentage point less than its annual average since 1970, Evercore’s data found.

Among S&P 500 sectors, consumer staples and consumer discretionary had the best average performance, both rising around 14% a year after the cut, while healthcare rose roughly 12% and technology gained nearly 8%, according to Evercore.

Small caps, seen as highly sensitive to signs of an economic turnaround, also outperformed, with the Russell 2000 rising 7.4% over the next year.

TREASURIES

Bonds have been a rewarding bet for investors at the start of rate-cutting cycles. This time around, however, Treasuries have already seen a huge rally, and some investors believe they are unlikely to run much further unless the economy experiences a recession.

Treasury yields, which move inversely to bond prices, tend to fall alongside rates when the Fed eases monetary policy. The safe-haven reputation of U.S. government bonds also makes them a popular destination during economic uncertainty. The Bloomberg U.S. Treasury Index returned 6.9% on a median basis 12 months after the first cut, Citi strategists found, but 2.3% in “soft-landing” economic scenarios.

The yield on the benchmark 10-year Treasury has fallen about 20 basis points this year and stands near its lowest level since mid-2023.

Further gains in Treasuries may be less certain without a so-called economic hard landing that forces the Fed to cut rates further than anticipated, said Dirk Willer, Citi’s global head of macro and asset allocation strategy.

“If you get a hard landing, yes, there’s a lot of money on the table,” Willer said. “If it’s a soft landing, it's really a bit unclear.”

That said, getting in early might be key. The 10-year Treasury yield has fallen a median nine basis points in the month following the first cut in the last 10 rate-cutting cycles and climbed a median 59 basis points a year after the initial cut as investors begin to price an economic recovery, data from CreditSights showed.

DOLLAR

The U.S. economy and the actions of other central banks have been important elements in determining how the dollar will react to a Fed easing cycle.

Recessions often require deeper cuts from the Fed, with falling rates eroding the dollar’s attractiveness to yield-seeking investors.

The greenback strengthened a median 7.7% against a trade-weighted basket of currencies a year after the first rate cut when the economy was not in a recession, an analysis by Goldman Sachs of the prior 10 cutting cycles showed. That compares to a 1.8% gain in the same time period when the U.S. was in a downturn.

At the same time, the dollar tends to outperform other currencies when the U.S. cuts alongside a number of central banks, according to a separate Goldman Sachs analysis. Rate-cut cycles that see the Fed moving alongside relatively few major banks, on the other hand, often result in weaker dollar performance.

The scenario of cutting alongside a number of other central banks appears to be in play now, with the European Central Bank, the Bank of England and the Swiss National Bank all cutting rates.

The U.S. dollar index , which measures the greenback's strength against a basket of currencies, has weakened since late June but is still up about 9% over the past three years.

“U.S. growth still stands out a little bit better than most countries,” said Yung-Yu Ma, chief investment officer at BMO Wealth Management. “Even though the dollar strengthened so much, we wouldn’t expect a meaningful degree of dollar weakness.”



That could change if U.S. growth sputters, analysts at BNP Paribas (OTC:BNPQY ) wrote.

“We think the Fed would be likely to cut by more than other central banks in a potential recession scenario this time around, further eroding the (dollar’s) yield advantage and leaving the currency vulnerable,” they said.

Source: Investing.com