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Fed Rate Cut: Its Not What You Think

The first rate cut in a cycle has been a reason to celebrate…if you are a stock market bear

The stock marketgot happy pretty quickly. But why? Economic growth is slowing in the U.S. and around the world, and a potential peak in corporate profits is in progress. Debt is still beyond obscene at the corporate, government and consumer levels. And, investor sentiment toward all of it is very complacent.These were all reasons for concern as the S&P 500 dropped over 6% during May. But the concern evaporated quickly as June began. What’s up with that? Answer: the Fed. That’s what’s up…or down, as the case may be. You see, the market expects the U.S. Federal Reserve to do whatever it can to keep the elongated economic party going a while longer. Their best way to do that is to take the interest rates they control (the very shortest-term ones), and reduce them.Some Wall Street pundits are cheering for a rate cut. They suggest that will make money easier to get. In turn, that allows more homes, vacations and cars to be bought. It also provides another opportunity for homeowners to refinance their mortgages at lower interest rates. In other words, it stimulates consumer spending.As for those piles of steaming debt that have built up since the Financial Crisis? They can stay out there a bit longer. Those owing large sums of money in the future could get a reprieve, in the name of squeezing a bit more juice out of the economy.

Rate Cuts Are Like Roaches

The Fed is unlikely to cut rates once and leave it be. Like roaches, there is rarely just one. Interest rates are raised gradually, to combat potential inflation and curb speculative economic activity (yeah, good luck with that!), and they are reduced the same way….gradually, successively. The past two times, the first cut was 0.50% (one-half of 1%), and the successive cuts were 0.25% (a quarter-point) each. This cycle could be similar.However, history tells us that the stock market’s reaction to rate cut hopes are playing out as they did the last two times the Fed did this. That was at the end of the year 2000, and in the second half of 2007. Both turned out to be just around the time the S&P 500 stock index went from teetering near an all-time high, to falling over and destroying wealth. Sure, history can be different. But you need to be aware that a rate cut now or soon is more likely an admission that the economy is indeed falling over.Related: Junk in the Trunk: The Story of Today’s Bond MarketThe table below shows the S&P 500’s return over different periods following the first Fed rate cut in a cycle. As you can see, the first rate cut has been a reason to sell the S&P 500, not buy it. I looked back at last century, and it appears to be similar. So be careful what you wish for, Mr. and Ms. Market.Rate cuts tend to happen right before recessions startWhat can you do about this? Recognize that a brief period of rising stock prices AND rising bond prices (as rates go down in anticipation of the Fed dropping them) may be very temporary. Sure, the cuts could be magical, and drive the economy to new heights. And, lower rates could have the effect of making it easier for the government and other market participants to refinance their debts at lower interest rates.

More sugar, please?

But to assume that this is more than another pump of syrup into your morning coffee is to ignore history. Be careful, pay attention, and don’t be complacent.To read more, click HERE