The Federal Reserve’s decisions on interest rates have long been pivotal in shaping the economic landscape. As we approach another potential shift in monetary policy, it’s essential to understand the historical context and implications of such moves. This article explores past instances where rate cuts have significantly impacted the stock market and what we might expect in the near future.
June 2007 Fed Rate Cut: The Prelude to a Crash
In June 2007, the Federal Reserve made its first interest rate cut, spurring excitement among investors. The US stock market surged to all-time highs in anticipation of easier monetary policy. However, this optimism was short-lived. The rally quickly fizzled out, marking the beginning of the most violent bear market since the Great Depression. This period serves as a stark reminder that initial market reactions to rate cuts can be misleading.
October 2000 Fed Rate Cut: A Grim Coincidence
A few years earlier, in October 2000, the Federal Reserve also began to cut interest rates. This move coincided almost perfectly with the onset of a significant market downturn. Over the next two years, the stock market experienced a staggering 50% drop.
Today’s High Rates
Fast forward to today, the US Central Bank’s interest rate is at its highest level since 2007, following the most aggressive hiking cycle in over 40 years. Despite these high rates, the stock market has performed remarkably well, reaching new all-time highs. However, the Federal Reserve is now preparing to cut interest rates, with market data indicating a high probability of such a move.
Market Expectations of Fed Rate Cuts
According to market data, there’s currently a 45.5% probability of a 25 bps rate cut in Sept and a 54.5% chance of a 50 bps cut. This essentially guarantees a rate cut in September, raising questions about the potential market impact.
The Relationship Between Fed Rate Cuts and Market Crashes
The last three times the Federal Reserve cut interest rates over the past 20 years coincided with the largest market crashes during that period. This pattern has led many to conclude that the upcoming rate cuts could signal a similar fate for the S&P 500.
However, it’s crucial to understand that large market drawdowns do not occur simply because the Federal Reserve is cutting interest rates. The Fed typically cuts rates in response to economic struggles. These rate cuts aim to counterbalance economic weaknesses. Therefore, it’s the economic downturns themselves that bring down the stock market, not the rate cuts.
Predicting the Future: Economic Indicators and Market Trends
We believe the US economy is heading towards a downturn, with reliable leading economic indicators pointing in that direction. As the Federal Reserve responds to this economic weakness by cutting rates, the stock market is likely to fall, pricing in the recession. It may take several years for the market to revisit current levels until the economy successfully emerges from the recession.
However, this outlook does not necessarily mean the peak of the bull market has already been reached. In 2007, the Federal Reserve began cutting rates in June, but the market only peaked in October, four months later. If a similar pattern follows today, there could still be several months of rally ahead.
Conversely, in 2000, the stock market peaked about two months before the Fed began cutting rates. If this scenario repeats, the market peak in mid-July might have marked the end of the bull run.
Not many pay attention to the timeline, but the difference between the scenarios in 2000 and 2007 is significant from a trading standpoint. This distinction can guide expectations for whether the market will go lower or higher from here.
Ongoing Market Correction
While we’re confident the US will enter a recession by year end, we don’t see an imminent danger for financial markets, unlike the topping process in 2007 or 2000. One reason markets are currently correcting is due to being overextended in mid-July 2024. The NAAIM Exposure Index, measuring active investment managers’ exposure, had reached a reading of 103. Readings above 100 mean managers are over 100% long on the market, indicating use of leverage.
We’ve used this indicator multiple times to judge whether the stock market is overextended. Often, when money managers are leveraged long, it leads to short-term pullbacks as they adjust their positions. This time has been no different, with the market correcting following the leveraged long positions.
Conclusion
While we anticipate a US recession by the end of 2024, this does not imply an immediate danger for financial markets akin to the 2007 or 2000 topping processes. Current market corrections are partly due to overextension in mid-July. Institutional overleveraging, as indicated by the NAAIM Exposure Index, suggests a period of adjustment. Historically, leveraged long positions lead to short-term pullbacks, and the market’s recent behavior reflects this trend. Click here to sign up! Subscribe to our YouTube channel and Follow us on Twitter for more updates!
