The "counterintuitive" impact of the Fed rate cut on US stocks

Introduction

There is a common understanding about the relationship between the Fed rate cuts and the US stock market, that is: Fed rate cuts are beneficial to the US stock market. It is important to note that this is not a theory, but rather a summary of an empirical rule.

Recently, the market trends have challenged this empirical rule.

On July 11th, the US released the CPI data for June:

In June, the US non-seasonally adjusted CPI rose by 3.0% year-on-year, with an expected increase of 3.1%, and a previous increase of 3.3%. The seasonally adjusted CPI for June decreased by 0.1% month-on-month, with an expected increase of 0.1% and a previous flat value. The non-seasonally adjusted core CPI for June rose by 3.3% year-on-year, with an expected increase of 3.4% and a previous increase of 3.4%. The seasonally adjusted core CPI for June rose by 0.1% month-on-month, with an expected increase of 0.2% and a previous increase of 0.2%.

The market implied a significant increase in rate cut expectations based on the two-year US bond yields, believing that the Fed will cut rates at the September meeting.

Ironically, on that night, the Nasdaq index plummeted by 1.95%.

This phenomenon challenges the empirical rule: once again, we have a sample - "rate cut expectations increase, US stocks fall".

So, how can we resolve this contradiction? How should we understand the relationship between Fed rate cuts and the US stock market?

In this article, we will transform this empirical rule into a theory:

If the Fed is the dominant player, then a rate cut will lead to a rise in US stocks; if the Fed is the subordinate player, then a rate cut will imply a decline in US stocks.

The Fed as the Subordinate Player

First, let's create a model where the Fed is the subordinate player.

As shown in the above diagram, US multinational corporations are divided into two main parts, domestic platforms and overseas supply chains. These large multinational corporations allocate their profits between domestic and overseas operations. As a result, we observe two different directions:

1. Overseas supply chains subsidize domestic platforms;
2. Domestic platforms subsidize overseas supply chains;

When multinational corporations move in coordination, we observe a cyclical pattern of the US dollar:

1. Profits flow back to domestic platforms, requiring the Fed to passively raise rates to curb inflation;
2. Profits flow overseas to subsidize supply chains, requiring the Fed to passively cut rates to hedge against economic downturn;

Recently, what we have seen is "coordinated inflow", leading to the "Seven Fairies phenomenon":

Within this framework, multinational corporations are the dominant force, while the Federal Reserve is the subordinate force, passively hedging against the collective actions of multinational corporations.

Therefore, there is no longer a causal relationship between the Fed's rate cuts and the U.S. stock market. Instead, the Fed's rate cuts have become a signal, indicating a shift in focus for multinational corporations from domestic to international markets.

As a result, the contradiction between the Fed's rate cuts and the decline in the U.S. stock market has also disappeared, with both responding to the collective actions of multinational corporations.

The U.S. Dollar Index and U.S. Stocks

If the strategic focus of multinational corporations shifts back to overseas markets, we will observe both a weakening U.S. dollar and a decline in U.S. stocks.

On July 17th, the U.S. Dollar Index plummeted significantly, while at the same time, the Nasdaq index dropped by 2.77%.

Currently, the market seems to be in a state of chasing shadows, trying various methods to observe whether multinational corporations are starting to tilt towards overseas markets. Any slight movement in this direction leads to a massive sell-off in the U.S. stock market. There are two simple observation methods:

1. Direct observation - if the U.S. dollar continues to weaken, it will be a direct negative signal.
2. Indirect observation - observe the subordinate force, if the capital's agent - the Federal Reserve - starts to turn dovish, it means the dominant force is shifting. Therefore, we still need to maintain flexibility, not immediately treat the Federal Reserve as the master of the U.S. If the financial conglomerates are strong enough, it is obvious that the Federal Reserve is just a follower. If the Federal Reserve is just a follower, then rate cuts are a bad signal.

Pressure from the U.S. Housing Market

Currently, mortgage rates in the U.S. are at a high level. However, there is a common understanding that high mortgage rates only create downward pressure on the U.S. housing market.

This understanding is incomplete. We should also add the second half, high mortgage rates also support the U.S. housing market.

This second half is a counterintuitive conclusion. So, why can such a conclusion be drawn??

In the current U.S. housing market, there is a group of people who previously took out loans to buy houses at rates of 3%+, and now with rates at 6%+, switching houses means borrowing 1 million with an additional cost of 30,000 per year, totaling an extra 900,000 over 30 years. Therefore, high rates limit everyone's ability to switch houses In other words, high interest rates have turned some houses into "restricted selling houses," which has a positive effect on house prices.

As shown in the above figure, higher mortgage interest rates will bring about two effects:

1. Suppressing buying pressure, causing the supply curve of funds in the market to contract from S1 to S2;

2. Suppressing selling pressure, causing people to be unwilling to change houses, leading to a contraction in the demand curve of funds in the market from D1 to D2.

As long as the latter force is strong enough, then, raising interest rates will lead to a seemingly paradoxical consequence, that is, the U.S. housing market will rise on shrinking volume.

At this point, if the Federal Reserve cuts interest rates, then, we will have to worry about the accelerated decline of the U.S. housing market, because many potential selling pressures will be released.

This is similar to a large number of stocks being unlocked due to a certain factor.

In summary, we have established a direct cause-and-effect relationship of "interest rate cuts bearish for U.S. stocks." Lowering interest rates will cause the U.S. housing market to "open blind boxes." We are not sure if the current U.S. housing market can handle "this wave of potential selling pressure," and U.S. stocks will also worry about "opening blind boxes and triggering bombs," so, U.S. stocks are concerned about interest rate cuts, especially rapid ones.

Conclusion

Overall, there is no necessary connection between the Federal Reserve's interest rate cuts and U.S. stocks, the kind of summary that has been statistically analyzed for many years is "not very meaningful," we need specific analysis for specific issues.

Sometimes, interest rate cuts by the Federal Reserve are beneficial to U.S. stocks, while other times, interest rate cuts by the Federal Reserve are a major bearish signal.

The benefit of empiricism is obvious: easy to understand, easy to convince oneself, forming some so-called "common sense".

However, its drawbacks are also significant, as long as a critical assumption changes, all the rules you believed in will wipe out all the money you made before.

Investors like to hear success stories, but what they need to be most vigilant about is empiricism.

Of course, these two theories are not necessarily the main contradiction, their role is to remind everyone not to forget other possibilities:

1. Multinational companies collectively going global will simultaneously lead to the Federal Reserve cutting interest rates, the U.S. dollar weakening, and U.S. stocks falling;

2. If you don't like the multinational company story, you can replace it with a common cause X;

3. If there are enough selling pressures locked in by interest rate differentials, then, interest rate cuts will lead to a decline in the U.S. housing market, thereby causing U.S. stocks to fall;

4. Empiricism kills, especially half-baked empiricism;

ps: Data is from Wind, images are from the internet