Will global sharemarkets rebound when the Fed cuts rates?

It’s not a question of whether the US Federal Reserve chairman Jerome Powell will announce a cut in interest rates, but rather why.

US Federal Reserve chairman Jerome Powell arrives to a dinner at the Jackson Lake Lodge on Thursday.

A US Federal Reserve interest rate cut in September now looks like an almost certainty. But how stocks might react to such a move is as murky as ever.

In theory, lower interest rates should help boost stock prices, since lower rates typically translate to lower borrowing costs, which allow companies to keep more of the money they earn through sales, Ritholtz Wealth Management chief market strategist Callie Cox says.

Rate cuts also boost the attractiveness of stocks compared with bonds by driving bond yields lower. Bond yields move inversely to bond prices.

But history shows that stocks don’t always climb after a first Fed rate cut.

Sometimes, indexes like the S&P 500 are lower – even dramatically lower – three months or even a year later.

When it comes to how stocks might react this time, the lesson is that ultimately, investors’ feelings about the strength of the economy will outweigh their enthusiasm for lower borrowing costs, according to Cox and Kevin Gordon, a strategist at Charles Schwab.

Put another way, it’s not just whether the Fed is cutting rates that matters for stocks. The reason for cutting them is important, too.

The economy really matters in terms of how markets respond to policy pivots,” Cox said during an interview with Market Watch.

“Is the Fed cutting interest rates out of celebration, or desperation?” she said. “If these are rate cuts out of celebration, then lower rates are really good for the stock market.

“But if the Fed has to swoop in out of desperation and cut rates, typically that’s bad for stocks.”

A Dow Jones analysis of how stocks have reacted to previous Fed cuts hinted at this divergence. According to Dow Jones market data, the Fed has embarked on five rate-cutting cycles since the early 1990s, when the Fed changed how it communicates policy shifts to the public by starting to announce changes to its target rate.

On average, the S&P 500 was up 2.5 per cent three months after the first cut. But that average belies rocky reactions to rate cuts in 2001 and 2007.

Three months after the central bank started cutting rates in 2001, the S&P 500 was down 10.7 per cent. And three months after the Fed cut rates in 2007, the index was off by 2.1 per cent, according to Dow Jones Market Data. A year after both those cuts, the index had chalked up double-digit losses.

Looking even further back reveals more evidence that the first rate cut doesn’t always bode well for stocks.

Data from Renaissance Macro showed that, since 1970, a lower Fed policy rate tended to coincide with an initial sell-off in stocks, provided the market reaction to the Fed’s most recent cutting cycle in 2019 is excluded.

Frothy valuations for large-cap stocks could make markets vulnerable to an adverse reaction this time around, especially as signs of a slowing economy and labour market could undermine Wall Street’s lofty forecasts for earnings growth.

A rate cut could tee up what some on Wall Street call a “buy the rumour, sell the news” reaction. Such a reaction occurs when stocks climb ahead of an anticipated event, only to sell off once it has passed.

Further muddying the waters is the notion that the central bank is preparing to cut rates during what has typically been the most volatile stretch of the year for stocks. September has been the worst month for stocks going back decades, according to Mark Hackett, chief of investment research at Nationwide.

Currently, stocks are poised for a soft landing for the US economy, stockmarket strategists said – meaning traders expect the Fed will succeed in lowering borrowing costs without sparking more weakness in the labour market.

But investors’ perceptions about the state of the economy can change in an instant. Just look at how stocks reacted earlier this month, when a weak July employment report triggered a growth scare that bulldozed global markets.

Going forward, investors will be keeping a close eye on all incoming economic data, Gordon said. But the August jobs report, due on September 6, will likely receive the lion’s share of the attention.

More disappointing jobs data could swing traders’ expectations toward a cut of 50 basis points.

During his speech at Jackson Hole, Wyoming, Federal Reserve chair Jerome Powell was believed to have left the door open to a more dramatic cut when he said it would do whatever was necessary to protect the labour market.