Rate cuts and record-high stocks are as American as apple pie

The S&P 500 ended less than 1% below its July 16 record closing high on Monday with the Federal Reserve poised to kick off an easing cycle this Wednesday.

Surely, US stock markets near all-time highs mean the central bank doesn’t have much need to be lowering rates, right? Well, history says something different.

From the start of Alan Greenspan’s tenure atop the Fed in August 1987 until the present day, 16 of the central bank’s 58 rate cuts — or more than one quarter — have come when the S&P 500 closed less than 3% below an all-time high the day before.

All but one time (in July 1992), cuts near all-time highs were only of the 25 basis point variety, while markets are currently pricing in a 50 basis point cut as more likely. 

Broadly speaking, the central bank either cuts interest rates because a) it’s behind the curve in responding to an ongoing economic deterioration or negative shock, or b) economic conditions are solid and the central bank wants to make sure they stay that way. We probably won’t really know whether we’re in Column A or Column B for a while.

The performance of the stock market as a whole, as well as interest rate sensitive segments of the market like housing-linked companies, seems to imply markets are betting on the latter, more optimistic outcome.

By taking rates down towards a more neutral policy stance, monetary policymakers are saying they want to become more supportive of growth, and improving financial conditions — i.e., stocks going up, credit spreads staying tight, and longer-term interest rates going lower — are a means to that end.

That being said, the Federal Reserve would (probably) want future gains in the equity market to be tied towards a stabilizing to improving earnings outlook rather than even higher valuations.

How to reconcile the current seeming dichotomy of investors pricing in easing that has seldom been delivered outside of a recession with a stock market near records? Well, the benign scenario probably looks something like this: some, but not all, of the easing expectations embedded in markets are realized over the next year, and medium to longer-term yields gently drift higher in the event that employment and earnings growth stabilize and improve as the easing cycle progresses.