Do markets really like rate cuts? The Federal Reserve tightened (raised) the “Fed Funds Rate” from June 2004 through September 2007 from 1.25% to 5.25%. The Fed cut rates that month (September 18, 2007), dropping them 50 basis points (one-half point). Typical (and historically – but not all) rate cuts are 25 basis points (quarter-point) cuts.
Three weeks later (October 9, 2007), the markets raced to new all-time highs. Apparently, investors liked the idea the Fed was now moving toward rate cuts.
10/09/07:
Closing high Dow Jones 14,034
Closing high S&P 500: 1,565
Note that between June 2004 and September 2007, the Dow Jones moved from (roughly) 10,000 up to 14,000, while interest rates moved up. Over the next year (2007-08), the Fed announced many more rate cuts, moving rates all the way to zero.
Did the market actually LIKE that?
No. Depending on where the lines are drawn, the market dropped by roughly 40% in late 2008 / early 2009.
Please remind me again why markets are supposed to like rate cuts?
Did the markets move down because the Fed introduced so many rate cuts?
Was this coincidental?
The Financial Standards Accounting Board (FASB) issued “Financial Accounting Standards #157 ” in September 2006. This accounting change had sweeping ramifications. This accounting change became effective for fiscal years beginning after November 15, 2007. FAS 157 returned “mark-to-the market” accounting. We wrote about mark-to-market accounting and its’ impact several times on the Mullooly Asset website in 2008 and 2009, including here.
Stretching from mid-2007 and into 2008, mortgage companies began closing shop. This accounting change would wipe out their earnings and crush their balance sheets to dust. Many mortgage companies had borrowed most of their capital from larger banks. Essentially the “mortgage sub-sector” of the finance area disappeared.
This mark-to-market accounting change reverberated straight through to banks and insurance companies. These changes challenged their sustainability. This contributed to a much bigger selloff in the market and problems throughout the economy.
Representatives Barney Frank and Paul Kanjorski announced they would hold a hearing to force the FASB to change Financial Accounting Standards No. 157. The date of that announcement? March 9, 2009. This is the date most market followers will state as the day the market bottomed.
So, it appears the markets initially went up because the Fed lowered rates. That sugar-high lasted about three weeks in the fall 2007. Rate cutting did not help stem the tide of bad events unfolding the next twelve months.
Tell me again why markets are supposed to like rate cuts?
Fast-forward to today: comments from Fed Chairman Powell in the fourth quarter of 2018 inferred he anticipated a good economy in 2019. He expected the Fed to continue on their path to several more rate hikes, throughout 2019. After those comments, markets slid nearly 20% quickly, before bottoming on Christmas Eve.
When the Fed began to “walk back” those statements in January 2019, the markets rallied roughly 20%. Markets are only now moving beyond the levels reached in January 2018 and in September-October 2018.
Why are markets supposed to like rate cuts? Does a “friendly Fed” imply smooth sailing for stocks? Or is the Federal Reserve cutting rates because they worry about an impending slowdown in the economy? Today, the current debate centers around whether the Fed should cut rates one quarter-point or a half-point. Questions:
- Is any rate cut necessary?
- What if the market gets a half-point rate cut?
- Does this imply the Fed sees danger ahead in the economy?
- What if the market expects a half-point cut, but gets a quarter-point cut?
- If there are no rate cuts at all at the next meeting, how will the market react?
Finally: will interest rate cuts even impact your investment plans?