Macro Signposts | 23 October 2024

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Fed Cuts and Market Responses: History Lessons

Since 17 September - the day before the Federal Reserve cut its policy rate by 50 basis points (bps) - the yield on the 10-year U.S. Treasury has climbed roughly 55 bps to 4.2%. This seemingly counterintuitive trend over the past several weeks has spurred questions around the extent to which the current Fed easing cycle will potentially deliver positive returns for bond investors, as has happened in past cycles.

While historical patterns are complex and not definitive, an analysis of previous Fed easing cycles suggests that bond market price action in the first month after the Fed begins cutting interest rates does not tend to be a good predictor of either 1) the broader macroeconomic outcome that ensues over the next year and beyond, or 2) the extent to which high quality bonds are able to deliver positive returns.

Indeed, historical analysis of bond total returns across Fed cutting cycles - both recessionary and non-recessionary - reveals that bond returns have tended to be positive, and in excess of the overnight funding rate, across a range of cycles and macroeconomic environments.

Equity market performance directly subsequent to the first cut has a similarly poor record of foreshadowing the ultimate macroeconomic outcomes, although equity performance at longer time horizons has been much more divergent and dependent on how the economy lands.

Rates markets are far from a crystal ball
We would caution investors from reading too much into the recent rise in bond yields. Over the past six major Fed rate-cutting cycles,1 the change in the 10-year Treasury yield a month after the first cut has not provided a consistent signal about the magnitude of further cuts or whether the U.S. economy falls into recession. In fact, yields rose in the month after the first cut more often than not (see Figure 1).

Figure 1: Yield on 10-year U.S. Treasury before and after initiation of major Federal Reserve easing cycles

Chart01
Source: Bloomberg, Federal Reserve, PIMCO calculations as of 21 October 2024

Consider two quick facts:

What about the equity market?
Equity market performance in the first month after the Fed starts cutting has been a similarly bad predictor of future economic performance (and market returns). Equities, more often than not, have tended to rise in the month after a cutting cycle begins, despite more significant divergence as time goes on.

For example, looking at the same starkly different cycles of 1995 and 2007 discussed above, equity returns (proxied by the Russell 2000 Index) in the month after the first cut were positive in both cycles (at 4.6% and 6.9%, respectively). However (and not surprisingly, given the divergent macroeconomic outcomes), equity market performance was down 4.4% in the year after the 2007 cut, while it was up 21% in the year following the 1995 adjustment.

History may rhyme even if it doesn't repeat
Despite the lack of historical correlation between markets' trading patterns in the first month after Fed cuts and the eventual depth of the cutting cycle or the subsequent economic environment, one outcome has been consistent across cutting cycles for decades: In a core bond portfolio (proxied by the Bloomberg US Aggregate Index), both total and excess returns historically have been positive in the year after the first cut. For example, in the 1995 soft-landing episode, a core portfolio returned 3.5% in that first year, while the 2007 episode saw even greater core bond returns. In other words, non-recessionary cycles have been generally decent for bonds, while recessionary cycles have been even better.

Investment takeaways
Although uncertainty surrounds the outlook for the U.S. economy - the upcoming U.S. election could be a major turning point for policy - recent U.S. macro data have been robust, and futures market now price approximately seven 25-bp Fed rate cuts in the first year of this easing cycle.

If we see a similar outcome to the soft-landing episode of 1995, then history suggests a portfolio of high quality core bonds has potential to generate a positive outright and total return. More importantly, however, in the event the U.S. economy is unable to stick the soft landing despite apparent recent strength, then past cycles suggest that total returns for fixed income markets could be even more positive.

History indicates that starting yields have been a good predictor of 5-year returns. The Bloomberg US Aggregate Index is yielding 4.5% currently, and with and the extra benefit of the negative correlation between daily bond returns and equities returning as inflation has normalized this cycle, one could argue that the bond market is effectively paying investors to diversify.

Not a bad outcome given the uncertain path ahead.

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1 A major Fed cutting cycle is defined here as a policy rate cut of at least 50 basis points before a subsequent rate hike; we exclude the 1998 cutting cycle, which represented only a 25-bp increase relative to the trough of the 1995 cycle, and thus effectively could be considered one elongated cycle.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions.

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