Fed cuts rates for the first time in over a decade

07.31.19

The U.S. Federal Reserve (Fed) reduced its target policy rate (“fed funds rate”) range by 0.25 percent today following its two-day meeting. The move was widely expected after a clear shift in messaging from the Fed’s prior meeting and recent speeches. Fed Chairman Jerome Powell indicated some reservations around multiple additional cuts, which markets are currently pricing in, though left the door open for additional rate cuts if warranted. Insurance against global economic weakening and muted inflation pressures were cited as reasons for today’s rate reduction. Market expectations for future cuts fell slightly, but still indicate reasonably high odds of two additional 0.25 percent cuts this year and one cut next year. Stocks fell on the news that Chairman Powell didn’t more forcefully endorse additional rate cuts. Investment performance across asset classes following initial rate cuts has varied historically, depending on whether the rate cuts were pre-emptive in nature or whether they were in response to significant economic deterioration. We continue to monitor the Fed and high frequency economic data.

Markets focused on the formal statement and Chairman Powell’s press conference, as the Fed provided no updates to economic projection documents at this meeting and a rate cut of 0.25 percent was already priced in. Chairman Powell stated that despite the strong U.S. labor market and domestic economic activity that has risen at a moderate rate, today’s rate cut “is intended to insure against downside risks from weak global growth and trade policy uncertainty, to help offset the effects these factors are having on the economy, and to promote a faster return of inflation to our 2 percent objective,” The Fed also announced an immediate halt to its balance sheet runoff, which had originally been scheduled for September. This indicates the Fed will continue to hold a large portfolio of assets for the foreseeable future and should be viewed as further modest stimulus, albeit expected. Importantly, Powell referred to today’s cut as a “mid-cycle adjustment to policy,” in contrast to a lengthy interest rate cutting cycle, dampening market hopes for aggressive future rate cuts. He later clarified he did not intend to imply this cut was “one and done.” Two voting members favored keeping the policy rate unchanged.

Short-term Treasury yields rose (prices fell), with the 2-year yield rising to around 1.87 percent, while 10-year Treasury yields fell slightly to 2.01 percent. Riskier assets, such as domestic and international stocks, fell between 0.50 to 1.25 percent, while high yield bonds and real estate investment trusts (REITs) were down close to 0.25 percent on the day. The U.S. dollar rallied around 0.30 percent. A seeming lack of commitment from Chairman Powell that further rate cuts are imminent triggered weak asset performance following the meeting. Fed communication remains disconnected with markets pricing three more rate cuts this year and next. Despite today’s reaction, investor sentiment remains strong, indicating that investors are maintaining high expectations for multiple rate cuts to prevent significant economic weakening in the U.S. This creates a potentially volatile market environment if the Fed does not deliver interest rate cuts in line with market expectations or if the economic outlook deteriorates significantly.

Investment performance varies after initial rate cuts

Our historical analysis indicates rate cuts can result in divergent investment performance depending on the type of environment. One scenario tends to occur when rate cuts result from the Fed taking pre-emptive but limited measures to ward off slowing economic data, followed by a steady fed funds rate or even a resumption in rate hikes (an “insurance” cut). Riskier assets like stocks tend to perform quite well and bonds underperform in these instances. However, when rate cuts coincide with further economic weakness, resulting in more aggressive ongoing rate cuts (a rate cut cycle), stocks often perform poorly, and lower risk bonds perform well. 

The graph below displays historical total returns for stocks and bonds split by various rate cut regimes since 1984. We refer to an “insurance” cut as a rate reduction of 1.00 percent or less, whereas a “rate cut cycle” refers to a series of fed funds rate cuts that well-exceeds 1.00 percent, with total cuts falling anywhere from approximately 2.00 to 5.00 percent. It is apparent that insurance cuts have preceded periods of strong stock returns and normal bond returns, while rate cut cycles more often preceded periods of weak stock returns and strong bond returns.

AVERAGE 12-MONTH RETURN FOLLOWING INITIAL INTEREST RATE CUT (1984-PRESENT)

Large cap stocks

Investment grade bonds

All periods

11.0%

6.8%

All cuts

11.2%

8.3%

Insurance cuts

19.8%

6.1%

Rate cut cycles

2.0%

11.0%

Source: U.S. Bank Wealth Management, 1/1/1984-6/30/2019. Large cap stocks represented by the S&P price return of the S&P 500 from 12/31/1983-12/31/1987 and the S&P 500 total return index from 1/1/1988-6/30/2019. Investment grade bonds represented by the total return of the Bloomberg Barclays U.S. Aggregate index.

It is premature to determine whether today’s 0.25 percent reduction to the Fed’s target funds rate is the beginning of an aggressive rate cut cycle that will coincide with material economic weakness or if economic data will stabilize to the extent a smaller number of cuts will suffice. Markets are currently anticipating rate cuts that fall into the “insurance” category based on market-implied pricing in rate markets, as well as somewhat elevated valuations in most segments of the stock and bond markets.

We remain focused on the trend in economic data in the United States and globally. We track hundreds of economic data points across the globe via our proprietary “Health Check” monitor, which indicates the global economy is on a path of a re-synchronized slowdown. The rest of the world is slowing and the U.S. economy, which had been outperforming, is now moving back in line with the rest of the world. However, odds of a recession, while rising, remain modest globally and subdued for the United States. In short, we anticipate economic weakness to persist, but will not represent cycle-ending economic weakness. 

As a result, we are maintaining our balanced assessment of risks between stocks and bonds, which is guiding our recommendation to hold stock and bond allocations close to long-term strategic target allocations. This reflects higher levels of volatility across global equity markets and lower bond yields in the United States relative to year-ago levels. Overall, we advise that bond portfolios be primarily comprised of high-quality bonds, to provide adequate portfolio diversification against riskier portfolio allocations.

As always, we value your trust and are here to help in any way we can. Please do not hesitate to let us know if we can help address your unique financial situation or be of assistance.

Article Disclosure

 

Investment and insurance products and services including annuities are:
NOT A DEPOSIT • NOT FDIC INSURED • MAY LOSE VALUE • NOT BANK GUARANTEED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY

U.S. Wealth Management - U.S. Bank | U.S. Bancorp Investments is the marketing logo for U.S. Bank and its affiliate U.S. Bancorp Investments.
U.S. Bank, U.S. Bancorp Investments and their representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation.
The information provided represents the opinions of U.S. Bank and U.S. Bancorp Investments and is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific investment advice and should not be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation.
For U.S. Bank:
Equal Housing Lender. Deposit products are offered by U.S. Bank National Association. Member FDIC. Credit products offered by U.S. Bank National Association and subject to normal credit approval.
U.S. Bank is not responsible for and does not guarantee the products, services, or performance of U.S. Bancorp Investments.

For U.S. Bancorp Investments:
Investment products and services are available through U.S. Bancorp Investments, Inc., member FINRA and SIPC, an investment adviser and a brokerage subsidiary of U.S. Bancorp and affiliate of U.S. Bank.
Insurance products are available through various affiliated non-bank insurance agencies, which are U.S. Bancorp subsidiaries. Products may not be available in all states. CA Insurance License # 0E24641.
Pursuant to the Securities Exchange Act of 1934, U.S. Bancorp Investments must provide clients with certain financial information. The U.S. Bancorp Investments Statement of Financial Condition is available for you to review, print and download.

The Financial Industry Regulatory Authority (FINRA) Rule 2267 provides for BrokerCheck to allow investors to learn about the professional background, business practices, and conduct of FINRA member firms or their brokers. To request such information, contact FINRA toll-free at 1.800.289.9999 or via http://brokercheck.finra.org. An investor brochure describing BrokerCheck is also available through FINRA.
U.S. Bancorp Investments Order Processing information.

© 2019 U.S. Bancorp