What will happen next after the historical "50 basis point rate cut"?

Wall Street generally expects that if the U.S. retail data announced tonight does not rebound like crazy, the Fed will start a rate cut cycle at its meeting later this week. However, as Nick Timiraos of the new "Fed News Agency" mentioned last Thursday, no one knows exactly how aggressive Powell and others will act.

As of the time of writing, the CME Group's FedWatch tool shows that there is a 67% chance of a 50 basis point rate cut in September, higher than 49% last Friday and only 15% the day before.

In the eyes of many major Wall Street banks, a 50 basis point rate cut seems a bit too hasty. Bank of America previously warned that a 50 basis point rate cut "makes no sense, is difficult to communicate, and may trigger flight to safety." In contrast, the more aggressive camp represented by Nomura Securities and JP Morgan believes that a 50 basis point rate cut is imperative.

Jack Hammond, head of U.S. bond sales at Nomura Securities, pointed out in a recent report that the actual U.S. unemployment rate may be higher than the Fed's forecast, and core PCE inflation may be lower than expected. Important FOMC members like Williams have hinted at agreeing to a significant rate cut. Nomura analyst Charlie McElligott pointed out that since the Fed has raised rates by 75 basis points several times before, starting a rate cut cycle with 50 basis points is not surprising and may not necessarily cause market panic.

After studying historical rate cut cycles, Nomura Securities found that three months after a 50 basis point rate cut by the Fed, the S&P 500 index remained basically unchanged, but small-cap stocks surged, tech stocks performed well, value stocks outperformed growth stocks again, the U.S. dollar rose, metal prices soared, and the yield curve steepened in a bull market trend.

JP Morgan expects the FOMC to cut rates by 50 basis points at the September and November meetings, followed by 25 basis points at each subsequent meeting. They also pointed out that the start of a Fed easing cycle often coincides with poor performance of risk assets.

Historically, after a "50 basis point rate cut", small-cap stocks surged, value stocks outperformed growth stocks again

Taking a lesson from history, almost every time the Fed started a rate cut cycle with a 50 basis point cut, the market performance was quite poor: January 2001 (after the dot-com bubble), November 2002 (economic slowdown), September 2007 (global financial crisis), and March 2020 (COVID-19 pandemic). But that's all in the past, as McElligott wrote in his latest report:

When people say, "Well, 50 basis points is telling the market that the Fed thinks there's a big problem with the economy, which could lead to a surge in risk aversion," my thought is, in this cycle full of oddities, nothing is normal (unprecedented monetary and fiscal interventions, market overreactions and underreactions, accompanied by sharp turns and institutional changes, causing momentum shocks) In fact, we have experienced 11 interest rate hikes by the Federal Reserve in a year and a half, including several significant hikes of 75 basis points each... So, it should be expected to take corresponding measures when there is a policy reversal, right?

Nomura studied all cases of previous 50 basis points rate cuts and analyzed market returns in the month before and after the rate cut by the Federal Reserve. Here are their findings:

• In the 30 days before the interest rate decision, the S&P 500 index on average fell by 1%, with consumer staples being one of the best-performing sectors, rising by an average of 0.8%, while the technology sector was one of the worst-performing sectors, falling by 2.6%.
• The small-cap Russell 2000 index fell by an average of 1.7%, with poor performance in energy stocks, industrial stocks, and precious metals. Value stocks outperformed growth stocks, and the yield curve showed a bullish trend.
• Three months after a 50 basis points rate cut, the S&P 500 index remained largely unchanged (except in 2007, 2001, and 1974 when the S&P 500 index suffered heavy losses). In contrast, small-cap stocks rose by an average of 5.6%. Technology stocks performed well, value stocks outperformed growth stocks again, the US dollar rose, metal prices soared, and the yield curve steepened in a bullish trend.

However, in the current unconventional economic cycle, Nomura's predictions may be inaccurate. After all, following the outbreak of the epidemic, household net wealth in the United States increased for the first time during a recession, the returns of the S&P 500 index remained robust, profit margins are growing, and the job market is relatively tight.

Today's America is more like 1995

For the above and other reasons, JP Morgan believes that investors may be "exploring uncharted territory." They also believe that the most similar situation to today may be the rate cut cycle that began in 1995, when the rate was cut by 25 basis points for the first time.

JP Morgan points out that the rate cut cycle in 1995 had two main backgrounds:

• The real GDP growth rate was 2.7%, CPI was 2.5%, and the unemployment rate was 5.7%. The non-farm payroll data for that year was only below 100,000 twice. Excluding those two instances, the average monthly non-farm payroll data was 207,000, but including those two instances, it was 179,000.
• M3 money supply grew rapidly, mainly due to a large influx of funds into money market funds (MMFs), whose yields slowly adjusted as money market rates declined.

The US stock market responded positively to the rate cut, with the S&P 500 index performing well TS Lombard analyst Dario Perkins believes that the "soft landing" in the United States in 1995 is a good sign for the Federal Reserve today.

In his report, Perkins wrote that there are no obvious imbalances in the current economic and financial environment, reducing the risk of serious problems occurring when the Federal Reserve falls behind the market curve. The Federal Reserve may take more aggressive rate cuts to avoid falling behind the market curve. If the Federal Reserve cuts rates by a smaller 25 basis points, it may trigger market volatility in September