The Fed's sharp interest rate cut is good for risk assets? Historical results are "counterintuitive"

Last Friday, Federal Reserve Chairman Powell sent a very clear signal: rate cuts will start soon and may continue in the foreseeable future. The market also responded very clearly: rate cuts are beneficial for all asset classes except the US dollar.

However, analysis indicates that historical trends do not support the initial market reaction last Friday, that is, a significant rate cut and a strong enough economy to support risk assets.

Liz Ann Sonders from Charles Schwab commented:

If you are hoping for the Fed to start an aggressive rate-cutting cycle, then you should be careful what you wish for. A significant drop in benchmark borrowing costs could be very detrimental to stocks and high-risk bonds.

In modern financial history, there have been 14 complete Fed cycles. Although the market's reaction to rate cuts varies at different times, there are some clear trends: when the Fed cuts rates quickly, the market performance is worse than in a gradual rate-cutting scenario. In a rapid rate-cutting scenario, the maximum drawdown within a year after the first rate cut is twice that of a gradual rate-cutting scenario.

So in reality, you should hope that the Fed cuts rates like an escalator, not an elevator.

While the market generally welcomes the shift in the Fed's monetary policy and sees it as positive overall, there are concerns that traders are envisioning an unrealistic scenario, leading to questionable pricing of related assets:

• Currently, according to the federal funds futures market, traders expect the Fed to cut rates by over 200 basis points by the end of next year, with eight rate cuts in the next eight FOMC meetings. At the same time, there is no actual economic downturn. This is a typical case of wanting it all.
• From the perspective of the credit and stock markets, it's a bit like whistling past the graveyard, assuming an economic soft landing, or at most a mild recession.

Many industry insiders believe that although some US economic data is somewhat weak at the moment, a severe economic downturn should be avoidable. In this situation, the number of rate cuts priced into the bond market seems excessive. If the Fed cuts rates significantly, the economic data would need to be very bad, accompanied by pricing in an economic recession. From the current situation, it seems that the market's rate cut expectations are overly optimistic from the Fed's perspective. At the same time, the market seems a bit too accustomed to believing that rate cuts are naturally beneficial for stocks.

Currently, the market's expectation for a 50 basis point rate cut at the September FOMC meeting has retreated from the market turmoil in August. Most Wall Street banks predict a 25 basis point rate cut by the Fed in September, but analysts at J.P. Morgan, Citigroup, and Wells Fargo still expect a 50 basis point cut.

Previously, prominent Bank of America analyst Michael Hartnett pointed out that since 1970, the Fed has had 12 "first rate cuts." When the Fed chooses to cut rates due to a Wall Street meltdown or a credit crisis, known as a panic rate cut, it will boost risk assets. Historical data shows that after each panic rate cut by the Fed, the S&P 500 index has averaged a 20% increase in the following 6 months.

However, Hartnett warns that this time is different. He advises investors to sell their assets decisively at the first rate cut of the Fed's current cycle. The uniqueness of this year lies in the fact that risk assets have risen to an extreme level - US stocks have risen by 32% in the first 9 months, while historically, the average increase in the stock market before the 12 "first rate cuts" was only 2%