• Wealth Management

Understanding the Surprise Fed Rate Cut

Markets became more volatile after the latest rate cut. Here’s why and what it may mean for your portfolio.

On Tuesday, the Federal Reserve surprised markets with a large, unplanned cut in interest rates. Normally, the Fed only cuts rates at scheduled meetings, usually by a mere quarter percentage point at a time. Tuesday’s cut was half a percentage point, so twice as large as typical.

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While markets often cheer rate cuts, especially during this business cycle, the history of such “emergency” rate cuts is often associated with true structural crisis. Does Tuesday’s outsized Fed action suggest rising risks of actual recession? It’s a reasonable question.

That’s perhaps why stock markets sold off following the rate cut—U.S. stocks fell about 2.5% and Treasury yields declined to near all-time lows that day. The last time the Fed cut rates this much at an unplanned meeting was late 2008, just as the financial crisis was bearing down on the economy.

Many questions about markets and the economy loom, but let’s take a look at the hard facts. Here’s what we know now:

  • Most corrections (a market drop of 10% or more) have not morphed into bear markets (a 20% or greater drop). However, U.S. stocks seemed overpriced and were facing a broader set of risks before the concerns about the coronavirus’ impact on growth set in.

  • Fed action is unlikely to have much impact on slowing growth due to self-imposed behavior tied to a health crisis. After all, financial conditions were already conducive to borrowing and spending before the latest Fed action.

  • Market performance after emergency rate cuts has often been poor, Morgan Stanley & Co. Research has found. The firm’s Global Cross Asset strategy team reports that six months after intermeeting rate cuts of at least half a percentage point, the median return for global equities was –6%.

  • Should genuine economic distress arise, the Fed has very little ammunition left to boost the economy with more rate cuts. The Fed funds rate, the main lever the Fed uses, is now pegged to 1% to 1.25%, low historically and far lower than the rate when the last few recessions started.

There’s a lot we don’t know—including the full scope and duration of the coronavirus outbreak and its impact on corporate profits and consumer confidence.

What Should Investors Do?

My advice depends on your time horizon. As long as you are investing for longer than six months, “patience, but preparedness” is the order of the day. Stay diversified, and look for active managers and companies with high-quality cash flows, value and earnings. I may recommend investors change their long-term strategic asset allocation plan, but I think more information is needed.

If you need cash in the next three-to-six months, reducing global equity exposure makes sense. I think the S&P 500 could return to recent lows around 2,600 points. Look to reduce exposure to index funds or large-cap growth stocks that have been leaders in this market cycle.

Remember that recessions are a normal part of the business cycle and not to be overly feared. U.S. stocks should be supported long-term by demographic changes and productivity improvements brought by new technology. The completion of one business cycle and transition to the next can create opportunities for investors to generate potential wealth.