The Fed's rate cut cycle is coming! Will the US stock market follow investors' script?

If everything develops as expected by the market, the Federal Reserve will cut interest rates for the first time since the outbreak of the COVID-19 pandemic in less than a week. This move is widely anticipated, and its impact may persist in the market for some time.

Traditionally, it is believed that after an interest rate cut, the U.S. stock market usually performs well. The Federal Reserve stimulates corporate and consumer spending by lowering borrowing costs, which is beneficial for the U.S. stock market.

However, strategists suggest that investors looking for a rate-cut playbook should take a more nuanced view, especially in the current unusual environment where the U.S. economy is still recovering from the distortions of the pandemic period and is dominated by soaring tech stocks. Jeff Buchbinder, Chief Equity Strategist at LPL Financial, said: "Every cycle is different."

The recent four major rate-cut cycles show why it is difficult to draw broad conclusions. Market performance after the start of a new easing cycle may vary significantly. The Morningstar U.S. Market Index rose over 21% in the 12 months following the Fed's rate cut in 1995, as the U.S. economy experienced a rare soft landing. However, after the bursting of the dot-com bubble in 2001 and the Fed's rate cuts, the returns dropped by over 10%.

Denise Chisholm, Head of Quantitative Market Strategies at Fidelity Investments, said: "Many investors believe there is a certain Fed rate-cut script, but in reality, there isn't."

The reasons for the rate cut are crucial

Behind these starkly different years are different market conditions and the Fed's attitude. If the market perceives that the Fed is confident in achieving an economic soft landing and in control of the situation, the market's reaction will be different from when the Fed is seen as reactively cutting rates in response to a recession threat.

Lara Castleton, Head of Portfolio Construction and Strategy at Janus Henderson Investors, said that to understand what might happen in the next year, "you need to think about why the Fed is cutting rates."

Chisholm pointed out that there are limited historical cases to refer to. Going back to the 1960s, there aren't many instances, "so you don't have a lot of robust data to evaluate."

Chisholm explained that about half the time, the Fed initiates easing because it believes the economy is heading towards a recession. In other cases, it lowers rates to recalibrate monetary policy rather than reacting to economic threats, some call it "preventative rate cuts."

Prepare for volatility

As always, no one can predict the market. Even with encouraging data, U.S. stocks are still driven by emotions.

Buchbinder said: "Even as the Fed starts its rate-cut cycle, the market will still be worried." After two lower-than-expected job reports, investors are trying to assess whether the Fed waited too long to cut rates, thereby opening the door to a recession Buchbinder added that most of the benefits of the upcoming rate cut cycle have already been priced into the US stock market, which has risen by over 24% in the past 12 months. He said: "The market has already benefited from the upcoming rate cut, so further gains may be limited." However, on the other hand, a real economic soft landing could bring more upside to the US stock market.

It is not immediately clear which scenario will unfold in the short term. Buchbinder expects the market to debate this in the coming months. He said: "That's why you see volatility around these inflection points and policy changes, they just add to the uncertainty."