After 10 years, the Federal Reserve finally decided to cut rates on July 31, 2019, after raising rates in December 2018. Then in 2020, the Federal Reserve decided to slash rates to 0% – 0.25% to help combat the coronavirus pandemic and lockdowns.
The S&P 500 crashed by 32% in March 2020 and investors are all hoping there is a recover in 2H2020 and 2021.
Let's see how the stock market (S&P 500) has historically performed after a Fed rate cut.
How The Stock Market Performs After A Rate Cut
A small rate cut is generally bullish for the stock market due to lower bowering rates and the belief the Federal Reserve will do what's possible to help the economy.
Since 1990, the S&P 500 has gained on average 0.16% on the day of a 25-basis-point cut. One-month later, the broad-market benchmark is 0.57% higher.
Double that cut and the market is 0.34% higher on the of the decision day and 1.25% higher a month later. A 75-basis-point reduction has resulted in a powerful 2.76% rally on average but 0.27% gain in the following 30-day period.
On the flip side, the greater the magnitude of the rate cut, the weaker the returns over the coming three and six months.
The ideal rate cut amount is a quarter-of-percentage point, resulting in an average return of 3.67% three months later and 5.64% in six months.
Cuts of 50-basis points and greater all resulted in losses in the coming quarter and half-year period, as the following table shows:
Invest With Caution After A Rate Cut
If the Federal Reserve is only cutting once or twice in 25 basis points increments, this is likely a good sign for investors. It shows the Federal Reserve doesn't believe it over-hiked on the way up, and it also shows investors there's no need to cut more aggressively because an economic slowdown is not as bad as expected.
Cutting by 25 basis points is often seen as an “insurance card,” and a good signal to investors. Couple a small cut with positive rhetoric by the Fed Chair, and we call this “moral suasion.”
If the Federal Reserve has to cut multiple times more aggressively, a recession and a downturn is highly likely to follow. See chart below.
The blue line is the historical effective federal funds rate. The shaded gray lines indicate a recession. The red arrows that I've drawn emphasize the correlation between the Fed rate cuts and a recession.
As you can clearly see from this unbiased chart, a recession almost always follows within 12 months after the Fed starts to cut rates.
It's important to understand that a recession does not occur because the Fed has cut rates. A recession follows because of the normal boom-bust cycle of the economy. The Fed is only making reactionary moves to try and prevent a recession because it is unable to predict accurately an economic cycle.
The Economy Is Always Boom-Bust
The classic boom-bust cycle can be illustrated by the housing market. The time-lapse between when developers first realize and then meet soaring demand for housing may be years because it takes time to build new apartment buildings and single-family homes. As more and more supply floods the market, prices fall.
The key is to have a large enough balance sheet to build and invest counter-cyclically, not at record high prices.
When it comes to the timeliness of rate increases or decreases, the Fed is perpetually behind. If the Fed was more efficient, the effective fed funds rate would be much less volatile and there would be no recessions.
The Fed certainly has more economic data at its fingertips than the average person. But even if the Fed foresees a dramatic slowdown in the future, it cannot transparently say so for fear of spooking the market. Thus, oftentimes the seeming lack of clarity in its statements. The Fed rightly fears that whatever it telegraphs will become a self-fulfilling prophecy and render its policy ineffective.
The Best Place To Invest After A Rate Cut
With interest rates declining, the best assets to invest in are interest-sensitive assets such as real estate and bonds.
As interest rates go down, bond values go up because their fixed coupon payments are more attractive. For example, if you had a bond paying 4% when the Fed Funds rate was at 2.5%, the bond is more valuable now if the Fed Funds rate is now at only 1%.
Real estate is attractive because as interest rates go down, the cost to borrow goes down as well. Purchasing power increases, putting upward pressure on real estate prices. However, if interest rates go too far down, it may signal that a massive slowdown is underway that will put more downward pressure on home prices.
During the 2000 dotcom bust, real estate & REITs performed extraordinarily well, significantly outperforming most other asset classes. Rents are also sticky on the way down given the difficulty of moving and one-year leases.
It's wise for all homeowners to at least try to refinance their mortgage in a declining interest rate environment. Check out LendingTree to get free mortgage rate quotes. If you can refinance at a break even cost less than 24 months, and plan to live in the house for years after, then refinance. I've personally refinanced into a 7/1 ARM at 2.75%.
Investors should consider investing in a real estate crowdfunding and REITs, which both offer a more diversified way to invest in real estate. Taking on massive leverage to invest in one property might have too much concentration risk if indeed the economy is going into a recession.
Instead, you can invest as little as $500 in a Fundrise eREIT that has dozens of properties in its fund that target a specific region or investment type e.g. growth, income, west coast, heartland, etc. I've personally invested $810,000 in a real estate crowdfunding fund after selling my SF rental property for 30X annual gross rent.
I believe there is a multi-decade demographic trend away from expensive coastal cities and into the heartland due to cost and technology.
Always invest in a risk appropriate manner that matches your risk tolerance. Only invest what you can afford to lose as risk is obviously involved. It's also good to have at least 10% of your investable assets in cash to take advantage of opportunities.
Whether you're in a bull market or a bear market, so long as you stay on top of your investments, you should do fine long-term.
About the Author: Sam worked in investing banking at Goldman Sachs and Credit Suisse for 13 years. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income. His most favorite right now is in real estate crowdfunding to take advantage of lower valuations and higher cap rates in the heartland of America. He spends time playing tennis, taking care of his family, and writing online to help others achieve financial freedom too.