How Do Stocks Perform After An Emergency Rate Cut

After the Federal Reserved conducting an emergency, inter-meeting rate cut on March 2, 2020, the stock market initially rallied a couple percent before selling off by more than 3%.

An emergency Fed rate cut is usually a NEGATIVE sign for the economy. The Fed, in all its wisdom, feels that they need to proactively cut rates because they are seeing ominous economic signs currently or on the horizon.

Ominous data include:

  • Deflation
  • Higher jobless claims
  • Supply chain slowdown
  • Global stock markets melting down
  • Foreign central banks cutting rates
  • A shock to consumer demand
  • A terrorist attack
  • The start of a great war
  • A global pandemic

How Do Stocks Perform After An Emergency Rate Cut

As you can see from the chart below, the median return of the S&P 500 over the next 250 sessions following a Fed emergency rate cut is a dismal 12%!

A median 12% decline is terrible when compared to the median return of 11.8% when there is no Fed emergency rate cut. That's a 23.8% swing!

In other words, whenever the Fed feels like it's necessary to go “off script” and cut rates, investors should worry that the economy and stocks will get worse.

The Fed Is Either Behind Or Ahead Of The Curve

When the Federal Reserve hiked rates at the end of 2018, this was a terrible policy move that showed Chairman Powell was not in touch with the markets and the economy. The S&P 500 ended up correcting by almost 20% until it bottomed on Christmas eve, 2018.

With the surprise 50 bps rate cut on March 2, 2020, the Fed is much more in tune with current events. They are signaling they understand the risks of the coronavirus and want to do everything possible to keep the economy humming along.

Even despite the emergency rate cut, the Fed probably still has to cut rates given the 10-year yield is at ~0.7% while the Fed Funds Rate (overnight rate) is still at 1.25% – 1.5%. In other words, there is an inverted yield curve going on, which creates disfunction in the banking sector.

Below is a 5-year chart of the 10-year yield curve with yields absolutely collapsing.

Interest rates collapsing in 2020

The Fed will probably have to cut another 50 basis points in 2020 if they want to correct the yield curve inversion, and encourage banks to lend more money to help grease the economy.

You Don't Want An Emergency Rate Cut

Based on the data, if you are a bullish investor, you don't want the Fed to conduct an emergency rate cut. It's just a bad signal that the economy is in a dire position and things could get much worse.

The good news is that the stock market doesn't stay long forever. Below is a chart that highlights the historical bear markets and bull markets, along with the S&P 500 percentage change and length of each market.

Average Bear Market correction and duration

Here is a graphical representation of the Dow Jones Industrial Average over time, including when the Fed conducted an emergency rate cut. As you can see from the chart, except for in 1999, the DJIA continued to decline.

Dow Jones performance with rate cuts over time

The main saving grace of an emergency rate cut is that the Fed Funds rate is lower. Therefore, interest rates from car loans to credit card loans should also tick down.

Mortgage rates are more influenced by US Treasury bond yields than the Fed Funds rate, since mortgages are usually longer term duration debt instruments. That said, during an emergency rate cut environment, you can bet that mortgage rates are declining as well.

Take advantage of lower an emergency Fed rate cut and refinance your mortgage or invest in real estate. Real estate tends to outperform stocks as investors rotate into more stable assets.

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