A Clockwork Cut
Key Takeaways
‘Fed watching’ is often an unreliable input into investment decisions because by the time the Fed announces and executes rate changes, markets would have already had time to form an expectation, react to it, and may not need to react any further.
For bonds you may be surprised to learn that a rate cut doesn’t always lead to a boost in bond prices as a decrease in yields. The results of past rate cuts on bonds have varied greatly.
If the Fed goes ahead with a September rate cut, it will be doing so during a period of relatively strong economic growth and with no recession in sight, which will serve to strengthen stock market performance.
“The influence on stock prices are so numerous and so complex that no person has ever been able to predict the trend of stock prices with consistent success.”
— John Templeton
People watching what the US Federal Reserve is likely to do would have been thrilled by Fed Chair Jerome Powell’s speech on Fri 23 Aug at the Jackson Hole symposium — an event where central bankers from around the world gather to discuss economic policy and signal major policy initiatives.
Fed Chair Powell indicates interest rate cuts ahead: 'The time has come for policy to adjust' — CNBC
Fed's Powell says 'time has come' to cut interest rates — CNA
However, ‘Fed watching’ is often an unreliable input into investment decisions because the Fed’s expected actions are already reflected in market prices. By the time the Fed executes rate changes, markets have already had time to form an expectation, reacted to it, and may not need to react any further.
For instance, the diagram above shows that following the early August blip, both stocks and bonds have risen steadily over the month right into the recent announcement. So if you were waiting for positive news to invest or allocate, you would be slightly behind the curve.
A look at Fed Funds Futures in June showed that there was already an expectation of a small September rate cut — two months before the announcement.
So through the wisdom of the crowd, the actions that Fed was about to announce were somehow reflected in interest rates ahead of time. Like what we have written about market efficiency before, this adds to the evidence that we need to trust broad diversified market prices to get a good investment experience, rather than relying on the opinions of a handful of experts.
As for how a rate cut can affect asset prices, we can refer to the following examples below.
For bonds (using Treasury bond prices as a proxy in the chart below), it is logical to think that a rate cut will lead to a boost in bond prices as yields go down. However, past examples show that there’s quite a lot of variation in market interest rates that is unrelated to changes to what the Fed does.
Varied and inconclusive effects of a rate-cut
The vast spread in outcomes from treasury bond prices after the first rate cut shows that the path for bonds is uncertain at best. This is a good example of why it’s hard for us to draw actionable conclusions from interest rate predictions.
So what about stocks? Central banks typically cut interest rates to stimulate their respective economies during economic slowdowns and downturns. If the Fed really does go ahead with a September rate cut, it will be doing so during a period of relatively strong economic growth and with no recession in sight.
Rate cut without recession good for stocks
Save for the 1968 example where stocks were affected by the end of THE Vietnam war fiscal tightening, stocks have enjoyed good runs whenever rates were cut without a recession in sight. However, we would warn that every economic cycle is different, and we can only reference history as a guide to what could happen in the future.
So with the news that the Fed is likely looking to do a September rate cut, should you abandon all your bonds and allocate it to stocks now? No! As what we have shown before, markets tend to incorporate news events very quickly into prices and sometimes even before it. Expectations of what central banks are going to do are not good inputs for your asset allocation decisions.
The best way to go about investing during this period is to stick to your investment plan. That means, investing in the right mix of stocks and bonds in the asset allocation that was deemed to be optimal for you. Switching things around because of news may not bring you the end result you desire.
To find out more about how a proper allocation can help you hit your goals in the most efficient way possible, come and speak to us.
