What to Expect After Rate Cuts

Jeffrey Roach (00:00):

I'm Jeffrey Roach, Chief Economist for LPL Financial. In this latest edition of the Street View Podcast, we'll address the question, what happens in year two after a cut in rates? Well, this year has been full of surprises. One of course was the weak start to the year. Then came Liberation Day, a market sell off, then a dramatic rebound. So let's take a step back and look at the macro backdrop on what's happening. And to do that, we need to go back to the nineties. In the mid 1990s, the Federal Reserve executed a textbook example of what's often called insurance easing. Well, that's cutting rates not in response to a recession, but to sustain and extend an economic expansion. After a sharp tightening cycle in 1994 that brought the Fed funds rate to 6%, the Fed pivoted in mid 1995 with a series of modest rate cuts totaling 75 basis points over three meetings.

Jeffrey Roach (00:58):

Well, these cuts were not driven by economic distress, but by a desire to fine tune policy amid slowing inflation and signs of decelerating growth. Importantly, the economy was still expanding and unemployment remained low. Markets responded with enthusiasm. The S&P 500 was already near record highs when the easing began, and the rate cuts were interpreted as a vote of confidence in the soft landing scenario rather than a warning of trouble ahead. Well, this helped fuel one of the most powerful bull markets in history with equities climbing steadily through the late 1990s. Bond markets also rallied as yields fell in response to the fed's more accommodative stance. The 1995 cycle is often cited as a model for how proactive non recessionary rate cuts can extend economic and market cycles. And that's without introducing instability, at least in the short to medium term. So let's look at what happens in the first and second year after the beginnings of a rate cutting cycle.

Jeffrey Roach (02:04):

The second year after a rate cut tends to be good for equities if a recession is averted. This is one reason why growth trajectories matter for investors. Those two times when the S&P 500 was negative was during the short-lived recession during 9/11 and during the great financial crisis. So if we can avoid a recession, and the data so far seemed to suggest that history tells us that year one and year two are often positive after the Fed starts cutting interest rates. Well, let me give you four reasons why growth should continue. One, August retail sales posted another strong month showing and Q3 economic activity looks better than expected. Two, consumers have taken tariff pressures in stride in three to five months from now. Those pressures will abate providing upward momentum for growth. Three, businesses have taken some of the hit to margins, but cost cutting over the past year gave businesses the leverage to successfully manage through tariffs. And four, Fed policy will ease in the next several quarters stimulating lending in the coming months. The key takeaway is that growth prospects are important for markets. If cuts are seen as a proactive insurance cut rather than reactive to a recession, markets tend to respond favorably. So for investors, understanding where we are in the business cycle is crucial. Well, that's all for now, but please follow us on social media and take care.