Change How You Think About Rate Cuts & Hikes Now!
The Fed just cut rates by 25 basis points, BUY BUY BUY! Fed cuts rates = buy equities might be the most Pavlovian response conditioned into market participants in modern history.
The reasoning behind it runs something along the lines of: Fed lowers interest rates = more money in the economy = good for the economy = good for stocks!
While there are many problems with this line of thinking, not least of which is its linearity, the biggest problem it faces is that it turns out to be nothing more than another fallacy.
As can be seen from the chart, rate cuts do not coincide with a rising stock market.
While Fed cuts rates = buy equities does hold true over shorter time frames, any traders who aren’t familiar with the above chart will get very badly burned; since rate cuts tend to herald large moves lower in stock markets over the medium term.
When the Fed started cutting rates in late 2007, the S&P had already topped out. A quick flurry of rate cuts after that were initially met with some cheer, and the market traded sideways for a while.
Ultimately though, the cuts did little to stop the mayhem that engulfed global financial markets as US equities sold off in sheer terror.
The Fed Funds rate tracked lower and lower with the market, until it hit a lower bound of 0%. (The Fed changed their target rate to an upper and lower limit in the midst of the crisis, instead of a single target rate previously)
The same thing happened in March 2020, when the Fed very quickly brought its target rate back to 0%, after starting to cut rates in mid 2019. The initial rate cuts in 2019 saw the S&P 500 surge to what were then record highs, only to crash back down as global markets, and the Fed, reacted to Covid.
It is important to note that the Fed starting to cut rates in 2019 shows that the US economy wasn’t in good shape even before Covid.
Over the two rate cutting cycles shown in the chart, US stocks only started rallying after rates hit rock bottom.
During the periods of time where they were being brought to 0%, US stocks sold off, in very big ways.
This makes sense, as the Fed only cuts rates when economic data and short term interest rate markets signal that conditions in the economy and banking system are starting to sour.
Such a scenario means that credit is in the process of becoming scarce, leading to lenders beginning to hoard liquidity for themselves and/or refuse to lend to riskier counterparties.
Tighter credit conditions provide the spark which lights the fire of margin calls and liquidations in the credit markets. Which, if serious enough, will spill over in a very big way into other markets, especially stocks and gold as people race to raise cash.
In other words, the beginning of fear creeping into the financial system. This fear, if supported by poor economic/political conditions, can turn an isolated sell off into a broad and vicious mass liquidation across all markets around the globe.
Obviously, none of this is bullish for risk assets, and the Fed, by cutting rates, seeks to ease credit conditions in the economy and financial system.
Unfortunately, the chart above shows that their efforts have never really worked out in the way they were supposed to.
Of course, all of this implies that the converse is true – rate hikes are not bearish for equities. Just look at the period between 2016 and 2018 on the chart, where stocks rallied as the Fed was raising rates.
Don’t be fooled by the interest rate fallacy and Pavlov’s bells!
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