History Says a Fed Rate Cut May Not Be Good for the Market

For months, the stock market bulls have been telling us that expectations of an imminent rate cut would power markets higher in the second half of 2024.

Wednesday's market activity seemed to validate their argument, with all three major indices trending higher after Fed Chair Jerome Powell held interest rates steady—but indicated that inflation is nearing the Fed's 2% target.

But history tells us, "Not so fast…"

For months, I've been warning that history is very clear that interest rate cuts come when something in the economy is breaking. The 2008-2009 crisis is the most stark example. But almost always, interest rate cuts signal a problem in the economy, like mounting unemployment, that will eventually take its toll on markets.

A September interest rate cut, therefore, will almost certainly be a bearish development. Of course, it won't be reported that way in the mainstream financial media—at least, not at first.

Despite what so many pundits say on Wall Street, lower interest rates are NOT a bullish sign for the stock market—and certainly not when they follow a significant tightening cycle like the one we went through in recent years. 

It's one thing when rates come down due to lower inflation, but it's another thing when it takes place due to a meaningful slowdown in growth.  When the latter happens, it is not good for a stock market…especially one that is as expensive as today's. 

Slower growth means lower earnings… and lower earnings mean a lower stock market, especially when the stock market has an elevated valuation and therefore plenty of room to fall.

This will be the case even if the slower growth doesn't push us into a recession.  (If it does push us into a recession, it will be extremely bearish.)

On the surface, there are certainly some silver linings in this economy.

Yes, it was great to see last week that the GDP growth in Q2 was higher than the consensus was looking for (2.8% vs. the 2.0% estimate). However, there is a reason that the GDP reports almost never have much impact on the markets. They're about as backward-looking as any data point economists look at on a regular basis. 

So, it was not a surprise that the Treasury market and stock market both ignored that report on Thursday and moved lower. However, we're getting a lot of evidence from forward-looking information, like the guidance from many consumer-related companies (Visa, Ford, American Airlines, Nestle, McDonalds, UPS, Coca Cola, and even BofA) that the consumer is really beginning to pull in their horns.

We also see the data on credit card balances that are past due… which have reached their highest level since 2012. On top of this, the housing market is showing some real signs of weakness.  So, there is no question that there are concerns about growth in the US going forward.

On top of all this, we have the former Fed NY Fed President Bill Dudley penning an article that came out last week saying that the Fed should cut interest rates now. This is a big change for him. Former Fed officials (especially former NY Fed Presidents who are extremely influential) do not write pieces like that lightly.  If he is seeing something that tells us that the Fed needs to be more aggressive, it's something we should all take note of. 

Heck, Mr. Dudley finished his piece by saying, "Although it might already be too late to fend off a recession by cutting rates, dawdling now unnecessarily increases the risk."  So, it doesn't seem like this VIP is overly bullish on the economic outlook right now.

As we've said many times, if the stock market was trading at 15x or 16x forward earnings, we'd be signing a different tune. However, as the charts we have provided below (and provided several times in recent weeks), it shows that when interest rates/bond yields roll-over after a significant rise, at a time when the stock market was expensive, it has been very, very negative for stocks.

So, investors need to be careful about what they wish for when it comes to lower short-term interest rates from the Federal Reserve.

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Photo Credit via Midjourney