Fed Rate Cuts: A Potential Pitfall for Stock-Market Bulls – Here’s Why

Deutsche Bank’s analysis indicates that throughout history, a reduction of 150 basis points in interest rates, equivalent to 1.5 percentage points, by the Federal Reserve has typically been linked to economic recessions.

Investors optimistic about a smooth economic slowdown find reassurance in market expectations that the Fed will implement such rate cuts in 2024.

However, historical data, as pointed out by Jim Reid, a strategist at Deutsche Bank, reveals that in most instances when the Fed has executed a 1.5 percentage point rate cut within a year, it has been in response to a recession.

The recent strong market performance, with record closes for the Dow Jones Industrial Average and a significant return for the S&P 500 in 2023, has contributed to this sentiment. Although there has been a slight pullback in stocks at the beginning of the new year, the 2023 rally gained momentum as investors anticipated a shift in Fed policy towards lower interest rates.

While rate traders have tempered their expectations for cuts in 2024, the CME FedWatch tool indicates a 53.8% probability of a 150 basis point or more reduction in the fed-funds rate by December. Reid highlights an exception to the recession pattern in the 1980s when Paul Volcker led the Fed, but this was preceded by rate hikes into “super-restrictive” territory, making it an atypical scenario compared to the current situation.

Another exception occurred in the late 1960s, accompanied by increased public spending due to the Vietnam War. However, this resulted in inflation, considered a policy error in retrospect. Reid emphasizes that the Fed aims to avoid a recurrence of such inflationary pressures.

Therefore, he concludes that historical precedents strongly suggest that the expected rate-cutting environment is more closely associated with a recession than a smooth economic landing.

If a recession does not materialize, the historical data suggests that achieving a 150 basis point reduction over 12 months would be a challenging outcome.

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