A Look at Bonds, Stocks, and the Fed Rate Cuts
Continuing the thought from my last post asking whether Fed Rate Cuts are Actually Good for the Market, I thought I’d compare the 2 Year Treasury Note, 30 Year Treasury Bond, and the S&P 500 and overlay the recent Fed Rate Cuts on the comparison chart.
Let’s see what happened:
The chart begins in June, 2007, when the Fed announced that it would likely stop raising interest rates for a period, and in fact, may begin cutting soon.
The Fed cut rates .50 basis points on August 17th, and then cut five additional times which have been marked on the chart with black lines at the bottom.
Notice how the S&P 500 responded to the first rate hike – with a euphoric 7% rally (which also experienced another rate cut). Notice also how the market topped at this point and began its violent downward descent from October 2007.
Notice also the 2 Year Note (green) and the 30 Year Bond Price (blue) and how they both responded to the first rate cut.
Bond prices move inversely to bond yields, meaning that if you bought a bond ETF or actual treasury notes/bonds, then not only did you experience appreciation from the monthly yields, but also from the fact that the prices actually rose in your favor as well (as could be expected in a period of falling yields).
I mentioned previously that it seems like everyone on the Street gets euphoric when the Fed cuts rates, but I vehemently disagree. The fact that the Fed is cutting rates is often a sign that the Fed and economists fear weakening economic conditions more than they fear inflationary concerns, and so they’re willing to ease monetary policy in response to deteriorating economic conditions.
Does the Fed also respond to the market? Yes, as evidenced by the surprise .75 cut on January 22nd. But even that drastic of a cut had little relative effect on the market.
Nevertheless, the actual strategy appears to be exit the market when the Fed begins a campaign of lowering interest rates and buy bonds/notes. Aggressive traders could have even decided to short the US Market, but smaller investors would be better off buying bonds during a campaign of Fed Rate Cuts instead of jumping aggressively into the market as Wall Street would have you believe.
Short sighted post with cherry picked short term data: If you look back to fed rate cuts and market performance to time periods predating 2000 you get completely different results. Market performed on average of 19% per annum from 1960-1998 when the fed was cutting.
Data from “The Role of Monetary Policy in Investment Management” Jensen, Johnson and Mercer. Published by AIMR November 2000
I agree that the time period is shorter than expected, but it’s taking into account the most recent 10 year period.
I will look beyond this time period and compare periods in an upcoming post for a broader picture. As a caveat, I’m certain that market prices would be far lower if the Fed had not cut rates at all during this period – that’s definite as well.
Thank you for the clarification.
The only thing I would add is that typically market valuations at the point in time of Fed rate cuts were reasonable even with a declining “E”. But there was really no saving the gigantic bubble that emerged from the fed rate cuts of early 2000 when the Nasdaq doubled.
I believe that criticism of the effects of rate cuts in post dot com era are misguided and simplistic. They fail to take into account the massive rally in Value stocks which were largely ignored in the late 90’s that lasted till 2006.
In sum, how does any stimulus save a stock market that was selling over 40x earnings?
That period was more the exception than the rule.
Brad
The rate cut on August 17th was not the O/N Fed Funds rate cut but a discount rate cut. The real O/N Fed funds rate cutting began on 9/18 (50BP) and then 25 on 10/31, followed by 25 on 12/10. While cutting the discount rates on 8/17 the FED indicated its “accodmodative” stance, which set up a temporary rally in equities, but marked the beginning of a huge rally in gold, commodities, oil, Ag etc which is still unfolding!