Executive summary
This report examines seven instances of Federal Reserve interest rate cut cycles since 1980 to identify patterns and potential forecasts for the financial landscape.
Key findings include:
- Rate cut cycles don't necessarily foreshadow recession (it happens at best 50% of the time).
- The extent of rate cuts varies significantly based on whether a recession is imminent or not.
- Employment data such as jobless claims and unemployment rate are a reliable indicator of economic health following rate cuts. The same is true for the spread between the 2-year and 10-year Treasury (which tends to increase if a recession is imminent).
- The most benefiting assets post rate cut are bonds, equities (particularly in non-recessionary environments), and gold (in case of a recession). In terms of allocation the 60/40 portfolio tends to perform well.
Introduction
As foreshadowed by Federal Reserve Chairman Jerome Powell at the recent Jackson Hole symposium, the central bank is poised to initiate a monetary easing cycle on September 18th. Using the Fed Chair words “The time has come for policy to adjust”.
Given the Fed's substantial influence on asset prices and the overall economy, we have examined historical monetary loosening cycles to identify patterns and potential forecasts for the financial landscape ahead.
To achieve this, we identified seven instances of rate cut cycles since 1980 and analyzed the subsequent macroeconomic data and asset price movements. While history may not repeat itself, it often rhymes, and thus, we can potentially glean some valuable insights from the past.
Overview of the Fed Interest Rate Cut Cycles
The seven identified instances of Fed rate cut cycles occurred in October 1984, June 1989, July 1995, September 1998, January 2001, September 2007, and July 2019 (we excluded June 1990 and March 2020 due to the Fed having already commenced its monetary tightening prior to those dates).
As illustrated in the chart below we can notice that among the seven rate cut cycles identified only two (2001 and 2007) were concurrent with a recession (the green bar indicates the start of a monetary loosening cycle). While three (1984, 1995 and 1998) happened without leading to a recession and two rate cut cycles (1989 and 2019) preceded a recession by more than 9 months (one of them being COVID-19 pandemic).
As we can see the initiation of an interest rate cut cycle does not necessarily herald the onset of a recession. Based on this data, at best rate cut cycles tend to precede recessions less than 50% of the time.
Analyzing the Magnitude of Rate Cuts
Overall, during those monetary loosening cycles the Fed tends to cut rates by 235 basis points (bps) within a year after the first cut. However, there is significant variability across categories.
Following the observation made earlier we decided to categorize the interest rate cut cycle into three main groups: rate cuts without recession (1984, 1995 and 1998), rate cuts ahead of recessions (1989 and 2019), and rate cuts coincident with recessions (2001 and 2007).
In the absence of a recession, the average rate cut is 188 bps although this figure is influenced by the 1984 cycle, which began with high interest rates and resulted in a substantial 375 bps cut. In contrast, the 1995 and 1998 cycles saw more modest rate cuts of only 25 bps and 75 bps, respectively.
Finally, when rate cuts coincide with recessions (like 2001 and 2007), the Fed is typically more aggressive, with an average cut of 400 bps.
Tracking Macro Indicators Around the First Fed Cut
As demonstrated above, the magnitude of rate cuts during a monetary loosening cycle is heavily contingent on the occurrence of a recession. Therefore, it is interesting to investigate which macro indicators can help signal the potential for an economic downturn.
Among the various indicators examined, those related to employment, such as jobless claims and the unemployment rate, proved to be the most decisive and timely. As depicted in the two charts below, a clear pattern emerges in recessionary cases, with unemployment and jobless claims consistently rising following the Fed's rate cuts.
Interestingly the Purchasing Managers Index (PMI), a highly followed indicator to track the health of the U.S economy on a monthly basis does not offer significant predictive power in terms of recession after the Fed has started cutting rates. As we can see in the chart below the PMI remains muted in all the post rate cut environments for a prolonged time before rebounding.
Asset Price Performance Post-Fed Rate Cuts
In terms of financial market performance we analyzed six different assets: The 30-year Treasury bond, the S&P 500, high-yield credit, oil, gold and the dollar index
Bonds: The 30-year Treasury bond consistently performs well during rate cut cycles (irrespective of the recession outcome) with rallies (move lower in yield / higher in price) commencing prior to the initial rate cut and continuing afterward. Interestingly, it is worth noting that a larger portion of the rally typically occurs before the first rate cut happens, with the post-cut gains concentrated within 80 days. Also, the performance post-rate cut is relatively similar across different recession scenarios.
Another interesting fixed income indicator to look at is the shape of the yield curve as measured by the spread between the 10-year and 2-year Treasury bond yield. As we can see from the chart below, for non-recessionary cases the yield curve does not tend to move much post rate cut. Notably though the curve experiences a sharp steepening when a recession is imminent (and the steepening also starts happening before the first rate cut happens). This would imply this financial market data is worth paying a close attention to.
Equities: The S&P 500 also exhibited strong performance, particularly in non-recessionary cases, with an average return of 20% within a year of the first rate cut. However, as it is expected the performance can be more volatile in recessionary environments.
Risk Parity: A risk parity strategy, combining 60% S&P 500 and 40% bonds, demonstrated a relatively robust performance in both non-recessionary and delayed recession scenarios while mitigating downside risk during recessions.
High-Yield Credit: As expected, high-yield credit performed well during non-recessionary periods. However, in recessionary cases, its performance was more volatile due to the interplay between declining yields (positive for credit assets) and widening credit spreads (negative for credit assets).
Gold: Gold exhibited strong performance in recessionary cases, likely driven by its status as a safe-haven asset and the decline in interest rates. Conversely, it tended to underperform in non-recessionary environments.
US Dollar: The US dollar did not exhibit a clear pattern following Fed rate cuts.
Oil: Similar to the US dollar, oil prices did not follow a consistent trend, with performance influenced by factors beyond monetary policy.
Conclusion
While none of the Fed monetary loosening cycles are the same we reviewed here some stylized facts.
Our analysis reveals that while the initiation of such cycles does not guarantee a recession, it can increase its likelihood. The magnitude of rate cuts is significantly influenced by the occurrence of a recession.
Furthermore, monitoring employment data (such as the unemployment rate and the jobless claim) can provide valuable insights into the economic trajectory and inform investment decisions.
Regarding asset performance, Treasury bonds tend to benefit from rate cuts (while the yield curve experiences some steepening in recessionary cases, further favoring shorter term Treasury bond)). Equities can also experience gains, especially in non-recessionary environments and the Risk Parity allocation performs relatively well. Finally, gold can serve as a safe-haven asset during recessionary events.
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