To The Moon

The market widely anticipates that the Fed will announce a rate cut this week. According to the CME FedWatch Tool, the probability of a 50-basis-point cut in September has even reached 59%. While a rate cut seems imminent, whether the stock market rises or falls post-cut hinges not on the cut itself, but on the reasons behind it.

Three Drivers

Goldman Sachs analyst Vickie Chang’s detailed analysis shows that historical data reveals the performance of the $S&P 500(.SPX)$ following a Fed rate cut is largely dependent on whether the economy is in a recession. The contrast is striking. Simply put, if the economy is in a recession, the stock market typically declines sharply. However, if the economy is in a “growth panic” or a “normalization” phase, the market often rallies strongly.

The key takeaway is that the reasons for a Fed rate cut matter a lot. Different reasons lead to different asset performances.

Goldman Sachs analyzed ten Fed rate-cut cycles since 1984. Four of these were associated with recessions (1990, 2001, 2007, and 2020), while the other six occurred during non-recession periods, categorized as either “growth panic” (1987, 1998, 2019) or “normalization” (1984, 1989, 1995).

“Growth panic” refers to a slowing economy that hasn’t yet turned into a full-blown recession. “Normalization” means the Fed is lowering rates from previously elevated levels to more sustainable ones.

In different economic contexts, the S&P 500 Index and other assets exhibit clear performance variations after the first rate cut. During a “growth panic,” the S&P 500 Index, or $SPDR S&P 500 ETF Trust(SPY)$ , rises by 11% within three months of the first cut and continues to climb to a 15% gain after six months. In a “normalization” period, the index rises 5% in three months and 7% in six months.

However, during a recession, the S&P 500 Index drops 11% within three months of the first rate cut and continues to fall by 10% after six months. The reason is that while the aim of the rate cut is to stimulate the economy, it’s often too late to reverse the recessionary trend. As a result, economic activity contracts, corporate profits decline, and the stock market remains sluggish.

Volatility Index

The $Cboe Volatility Index(VIX)$ (Volatility Index) reacts differently under various economic conditions. During a “growth panic,” volatility sharply decreases after the first rate cut. In a “normalization” period, volatility spikes by 17% in the short term (three months) but then stabilizes, dropping to -1% after six months. In contrast, during a recession, the VIX rises by 21% within three months of the first rate cut and remains high, increasing by 9% after six months.

Conversely, during a recession, the VIX typically rises, jumping 21% and 9% after three and six months, respectively. As for bonds during a recession, the two-year Treasury yield typically drops by 65 basis points after three months and continues to fall by 82 basis points after six months. The 10-year Treasury yield decreases by 23 and 30 basis points, respectively.

Market Behavior

In recession periods, rate cuts are usually accompanied by significant drops in stock and bond yields, along with a surge in volatility.

During “growth panic” or “normalization” phases, stocks tend to rise, bond yields decline moderately, and volatility decreases as market participants regain confidence.