Blog Posts — September 13, 2019

The Fed’s ‘insurance’ cut? Not cutting it…

by Christoph Schon, CFA, CIPM

The 25-basis point downward move in the Federal Funds Rate target range at the end of July was meant to be an ‘insurance’ cut to support the US economy and bolster asset prices. But the immediate market reaction indicates that investors are anything but reassured. Within days, US share prices dropped by almost 5%, while the 10-year US Treasury yield fell below the 2-year rate for the first time in 12 years. At the same time, the 30-year benchmark rate declined to its lowest level ever recorded, yielding barely more than the lower boundary of the Fed Funds target range.

US Treasury Zero-Coupon Yield Curve

Source: Axioma Multi-Asset Class Risk Monitor

Market reaction to the latest monetary policy decision stood in sharp contrast to the Fed’s previous three rate-lowering cycles, in which share prices continued to rise for at least another 4 weeks following the first rate move—irrespective of the size and reason for the cut. The table below shows simulated returns for a large-cap US equity portfolio—using the historical stress-testing capabilities of the Axioma Risk™ platform—for the first month and then 3-4 months following the first cut. As we noted in our previous blog post ahead of the July 31 FOMC meeting, the returns over the longer horizon depended on what was perceived as the reason for the move. The size of the first step could be considered an indication of the Fed’s assessment of the economic outlook: 25 basis points meant ‘insurance’, while 50 points painted a much bleaker picture.

Simulated Returns for US large-cap stocks

Source: Axioma Risk

Comparing the last two columns of the table suggests that the current stock market returns are more reminiscent of the performance observed in the first 4 months of the 2007 easing cycle. Similarly, the 2007 cut was also accompanied by a yield-curve inversion, which—like all previous inversions of the past 60 years—was, in turn, followed by a recession. At the time of writing, short-term interest rate futures indicated that traders firmly expected another 25-basis point move at the Sep. 18 FOMC meeting, but only a 37% probability that it would be followed by another downward step at the end of October. This is once again in stark contrast to the past two instances of yield-curve inversions, when the Federal Reserve took much swifter and more aggressive action than is implied by futures markets.Source: Axioma Risk

Based on past experience, however, the odds are firmly in favour of the bond market and its gloomier prediction for the US economy and financial markets. That said, our previous research also suggests that it might yet be a few more months before GDP growth actually turns negative and share prices begin to head south in earnest. But investors should still prepare and stress tests like the ones described above can be a powerful tool.