As the Fed moves closer to tapering, the health of the US economy could determine the path of markets, by Reuters

By Lewis Krauskopf, Prinz Magtulis, Pasit Kongkunakornkul and Vineet Sachdev

NEW YORK (Reuters) – How stocks, bonds and the dollar fare after the Federal Reserve begins its rate-cutting cycle could depend on one factor more than most: the health of the U.S. economy.

The Fed is expected to begin a series of rate cuts on Wednesday after raising borrowing costs to the highest level in nearly two decades. Markets are pricing in about 250 basis points of easing by the end of 2025, LSEG data showed.

For investors, a key question could be whether the Fed will cut rates in time to avoid a potential economic slowdown.

It fell an average of 4 percent in the six months after the first cut in a rate-cutting cycle if the economy was in recession, data from Evercore ISI shows since 1970. That compares with a 14 percent gain for S&P 500 when the Fed cut in a non-recession period. The index increased by 18% in 2024.

“If the economy goes into recession, rate cuts are not enough support to offset falling corporate profits and high uncertainty and lack of confidence,” said Keith Lerner, co-chief investment officer at Truist. Counseling services.

Treasuries have outperformed during recessions as investors seek the safety of US government bonds. The dollar, meanwhile, tends to rise less during a recession, though its performance could depend on how the U.S. economy fares relative to others.

STOCKS

Recessions are usually called retrospectively by the National Bureau of Economic Research, and for now, economists see little evidence that the U.S. is currently experiencing one.

These conditions bode well for gains in US stocks if they persist.

“Based on previous easing cycles, our expectations for aggressive rate cuts and no recession would be consistent with strong US equity returns,” James Reilly, senior market analyst at Capital Economics, said in a report.

However, worries about the economy have shaken asset prices in recent weeks.

Weakness in the U.S. labor market helped fuel sharp swings in the S&P 500, while concerns about global growth were reflected in lower commodity prices, trading near their lowest level since late 2021.

Uncertainty over whether growth is just falling back to its long-term trend or showing signs of a more serious slowdown is being reflected in futures markets, which in recent days have oscillated between pricing in a 25- or 50-basis-point cut on Wednesday.

The state of the economy is important to investors looking to gauge stock performance over the long term as well. The S&P 500 is down nearly 12% on average a year after an initial drawdown that occurred during a recession, according to a study by Ryan Detrick, chief market strategist at the Carson Group.

That compares with an average gain of 13 percent following cuts that came in a non-recession period, when the cuts were supposed to “normalize” policy, according to the data, which looks at the past 10 easing cycles.

“The bottom line of this whole thing is that the economy is avoiding recession,” said Michael Arone, chief investment strategist for State Street (NYSE:) Global Advisors.

Overall, the S&P 500 was 6.6 percent higher a year after the first rate cut of a cycle — about a percentage point less than its annual average since 1970, Evercore data found.

Among the S&P 500 sectors, consumer staples and consumer discretionary were the best average performers, both up about 14% a year after the discount, while healthcare was up about 12% and technology gained nearly 8%, according to Evercore.

Small caps, seen as highly sensitive to signs of an economic recovery, also outperformed, rising 7.4% over the next year.

THE DREAMS

Bonds have been a rewarding bet for investors at the start of rate cut cycles. However, this time around, Treasuries have already seen a huge run-up, and some investors think they’re unlikely to go much further unless the economy goes through a recession.

Treasury yields, which move inversely to bond prices, tend to fall alongside rates when the Fed eases monetary policy. The safe-haven reputation of US government bonds also makes them a popular destination during economic uncertainty. The Bloomberg index of US Treasuries returned 6.9% on a median basis 12 months after the first cut, Citi strategists found, but 2.3% in “soft landing” economic scenarios.

The yield on the benchmark 10-year Treasury has fallen about 20 basis points this year and is nearing its lowest level since mid-2023.

Additional Treasury gains could be less certain without a so-called economic hard landing that forces the Fed to cut rates more than anticipated, said Dirk Willer, Citi’s global head of macro strategy and asset allocation.

“If you get a hard landing, yeah, there’s a lot of money on the table,” Willer said. “If it’s a soft landing, it’s really a bit of a blur.”

That said, getting in early could be the key. It fell an average of nine basis points in the month following the first cut in the last 10 rate cut cycles and climbed an average of 59 basis points a year after the initial cut as investors begin to price a economic recovery, data from CreditSights showed.

DOLLAR

The US economy and the actions of other central banks have been important elements in determining how the dollar will react to a Fed easing cycle.

Recessions often require deeper cuts by the Fed, with falling interest rates eroding the greenback’s appeal to yield-seeking investors.

The greenback rallied an average of 7.7 percent against a trade-weighted basket of currencies a year after the first rate cut, when the economy was not in recession, a Goldman Sachs analysis of 10 cycles showed previous discount. That compares with a 1.8% gain during the same time period when the US was in recession.

At the same time, the dollar tends to outperform other currencies when the U.S. cuts alongside a number of central banks, according to a separate Goldman Sachs analysis. On the other hand, rate-cutting cycles, which see the Fed moving alongside relatively few major banks, often result in the dollar underperforming.

The cut scenario along with a number of other central banks appears to be in play now, although the European Central Bank, the Bank of England and the Swiss National Bank are cutting interest rates.

which measures the greenback’s strength against a basket of currencies, has fallen since late June but is still up about 9% over the past three years.

“U.S. growth is still showing up a little better than most countries,” said Yung-Yu Ma, chief investment officer at BMO Wealth Management. “Even though the dollar has strengthened so much, we would not expect a significant degree of dollar weakness.”

That could change if U.S. growth falters, analysts at BNP Paribas ( OTC: ) wrote.

“We think the Fed is likely to cut more than other central banks in a potential recession scenario this time around, further eroding (the dollar’s) yield advantage and leaving the currency vulnerable,” they said.