This is how the markets could develop after the first US interest rate cut

How stocks, bonds and the dollar perform after the Federal Reserve begins its interest rate cutting cycle could depend on one factor above all: the health of the U.S. economy.

The Federal Reserve is expected to begin a series of interest rate cuts on Wednesday after raising borrowing costs to their highest levels in nearly two decades, with markets pricing in an easing of around 250 basis points by the end of 2025, LSEG data showed.

The key question for investors will be whether the Fed will cut interest rates in time to avert a possible economic downturn.

The S&P 500 has fallen an average of 4% in the six months following the first cut of a rate-cutting cycle when the economy was in a recession, according to data from Evercore ISI since 1970. By comparison, the S&P 500 rose 14% when the Fed cut rates during a non-recessionary period. The index will rise 18% in 2024.

“When the economy enters a recession, interest rate cuts are not enough to offset the decline in corporate profits and the high levels of uncertainty and lack of confidence,” said Keith Lerner, co-chief investment officer at Truist Advisory Services.

Treasuries have performed better during recessions as investors seek the safety of U.S. Treasuries. The dollar, on the other hand, tends to rise less during a downturn, although its performance may depend on how the U.S. economy performs relative to others.

Shares

The National Bureau of Economic Research typically predicts recessions after the fact, and economists currently see little evidence that the United States is currently in one.

These conditions bode well for the recovery in US equities, if they continue.

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

Nevertheless, economic concerns have led to a rise in asset prices in recent weeks.

Weakness in the US labor market has contributed to sharp swings in the S&P 500, while concerns about global growth are reflected in falling commodity prices. The price of Brent crude oil is currently near its lowest level since late 2021.

Uncertainty about whether growth is simply returning to its long-term trend or showing signs of a more serious slowdown is reflected in futures markets, which have fluctuated in recent days between pricing in a 25- or 50-basis-point cut for Wednesday.

The economic situation is also important for investors who want to assess the long-term performance of stocks. According to a study by Ryan Detrick, chief market strategist at the Carson Group, the S&P 500 lost an average of almost 12 percent a year after its first cut during a recession.

In contrast, the average increase in interest rate cuts in non-recessionary periods of monetary policy “normalization” was 13%, according to data examining the last ten easing cycles.

“The crux of the whole thing is that the economy avoids a recession,” said Michael Arone, chief investment strategist at State Street Global Advisors.

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

Among the S&P 500 sectors, consumer staples and consumer discretionary performed best, both up about 14 percent a year after the cut, while health care rose about 12 percent and technology rose nearly 8 percent, according to Evercore.

Small caps, which are particularly sensitive to signs of an economic turnaround, also performed better: the Russell 2000 rose by 7.4 percent in the following year.

Treasure chambers

Bonds have been a lucrative investment for investors at the start of rate-cutting cycles. This time, however, Treasuries have already enjoyed a huge rally, and some investors believe they won't rise much further unless the economy goes into recession.

Treasury yields, which move inversely to bond prices, tend to fall along with interest rates when the Fed eases monetary policy. Treasuries' reputation as a safe haven also makes them a popular investment destination in times of economic uncertainty. Citi strategists found that the Bloomberg US Treasury Index returned a median of 6.9% 12 months after the first cut, but only 2.3% in “soft landing” scenarios.

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

Further gains in government bonds may be less certain without a so-called hard landing of the economy that forces the Fed to cut interest rates more than expected, said Dirk Willer, global head of macro and asset allocation strategy at Citi.

“If there's a hard landing, there's a lot of money at stake,” Willer said. “If there's a soft landing, it's really a bit unclear.”

However, getting in early could be crucial. The yield on 10-year U.S. Treasury bonds fell an average of nine basis points in the month following the first cut in the last 10 rate-cutting cycles and rose an average of 59 basis points a year after the first cut as investors begin to price in an economic recovery, data from CreditSights show.

dollar

The U.S. economy and the actions of other central banks have been important factors in determining the dollar's response to a Fed easing cycle.

Recessions often require deeper cuts by the Fed, with falling interest rates reducing the dollar's attractiveness for yield-seeking investors.

A year after the first rate cut, when the economy was not yet in recession, the greenback gained an average of 7.7 percent against a trade-weighted basket of currencies, according to an analysis of the previous 10 rate-cutting cycles by Goldman Sachs. During the same period, when the US was in recession, the greenback gained 1.8 percent.

At the same time, the dollar tends to outperform other currencies when the US cuts interest rates along with a number of other central banks, according to a separate analysis by Goldman Sachs. Rate-cutting cycles in which the Fed cuts interest rates along with a relatively small number of large banks, on the other hand, often result in weaker dollar performance.

At present, the scenario of a reduction in line with a number of other central banks seems to be on the table; for example, the European Central Bank, the Bank of England and the Swiss National Bank have all cut their key interest rates.

The US dollar index, which measures the strength of the greenback against a basket of currencies, has declined since late June but is still up about 9 percent over the past three years.

“US growth is still a little better than in most other countries,” said Yung-Yu Ma, chief investment officer at BMO Wealth Management. “Even though the dollar has strengthened so much, we would not expect any significant dollar weakness.”

That could change if US growth stalls, write analysts at BNP Paribas.

“We think that in a potential recession scenario, the Fed would likely make deeper cuts this time than other central banks, further eroding the yield advantage (of the dollar) and leaving the currency vulnerable,” they said.