The inescapable signal of a Fed rate cut

The Federal Reserve maintains a consistent, albeit uncomfortable, doctrine: it does not cut the short-term Federal Funds Rate into a demonstrably strong economy. An easing of monetary policy is fundamentally at odds with an environment characterized by robust GDP growth, tight labor markets, and persistent inflationary pressures. When the economy is performing optimally, the central bank’s primary concern remains stability and price control, necessitating a neutral or restrictive stance. Therefore, the first rate cut following a significant tightening cycle should never be viewed as a reward for economic strength. Instead, it is a signal—a tacit admission by the Federal Open Market Committee (FOMC) that the prior restrictive policy has finally slowed demand sufficiently, and that the underlying economic momentum is beginning to stall. It is the central bank acknowledging that the risk has officially shifted from inflation to unemployment and contraction.

This critical signaling function leads directly to the next point: for each quarter-point reduction, the statistical probability of a recession in the very near future noticeably increases. A 25-basis point cut is rarely a pre-emptive, surgical strike; it is often a reactive measure taken when leading indicators, or even coincident data, begin to seriously falter. The Fed is not merely easing; it is attempting to manage a deterioration that has already begun. The deeper the central bank is forced to cut—moving from an initial 'insurance' cut to a pattern of successive, reactive cuts—the more apparent it becomes that the economic ailment is severe. These incremental reductions, therefore, function less as instant stimulus and more as a lagging indicator of accelerating risk, confirming that the central bank’s restrictive measures finally broke something critical in the economic engine.

History offers a chilling confirmation of this pattern, which holds true almost all the time. Since the early 1970s, nearly every significant Fed easing cycle that followed a sustained period of rate hikes has culminated in, or immediately preceded, a recession. The initial cuts that mark the beginning of an aggressive easing phase are typically followed by a full-blown economic downturn within the subsequent 12 to 18 months. While policymakers and commentators occasionally dream of achieving a perfect 'soft landing,' the data suggests that once the Fed has tightened enough to necessitate a decisive pivot to cutting, the underlying damage is already done, and the recessionary forces have been unleashed. Prudent investors must view the commencement of a rate-cutting cycle not as a cause for celebration, but as a definitive, high-confidence warning sign that the economy is transitioning into a high-risk phase.

Fed rate cuts and the two recent recessions

Summary

- The last two recessions were preceded by Fed rate cuts.

- Stock market reactions were somewhat different in the two recessions.

- In the early 2000s recession (March 2001 to November 2001) the stock market was already going down by the time the Fed started cutting rates, and continued going down.

- In the Great Recession (December 2007 to June 2009) the stock market reaction to the Fed cutting rates was more optimistic, with a three-month rally that saw the S&P 500 go up by a little less than 10 percent.

- After that initial rally, the stock market dropped by more than 50 percent (in early 2009), with several “sucker rallies” in between.

- Generally speaking, a Fed rate cut at a period when the signs of an upcoming recession are pilling up should be a source of concern for stock market investors.

The last two recessions were preceded by Fed rate cuts

The graphs below are for the period from January 1999 to June 2019, and were generated using Yahoo Finance and the US Federal Reserve Economic Data (FRED) (, ). The graph at the top shows the weekly variation in the S&P 500 index together with its 50-month simple moving average. The graph at the bottom shows the effective federal funds rate.

As you can see, the last two recessions were preceded by Fed rate cuts. The dashed lines suggest that stock market reactions were somewhat different in the two recessions. In the early 2000s recession (March 2001 to November 2001) the stock market was already going down by the time the Fed started cutting rates, and continued going down.

In the Great Recession (December 2007 to June 2009) the stock market reaction to the Fed cutting rates was more optimistic, with a three-month approximately 10 percent rally in the S&P 500. After that, the stock market dropped more than 50 percent, with several “sucker rallies” () in between. Those rallies are common in recessions, including the early 2000s recession.

We want the debt that we do not need

Since there have been many previous recessions before the last two, some business commentators refer back to several of those other recessions to predict the future, and to frame Fed rate cuts in a positive light. Lower rates stimulate economic activity by making credit more easily and widely available, which could in theory prevent a recession.

The problem is that it is human nature to buy more than we can afford, or need, if we can fund those purchases through debt. Most people will want to buy a more expensive car on credit than they can afford either paying cash or with higher interest rates; the latter increase monthly payments. The same goes for homes.

This is all about perceived status, and extends to corporations. Other things being equal, a CEO of a larger and more dominant company will have a higher status among peer CEOs. As a result, companies tend to take on more debt, if it is easily available at low rates, to fund acquisitions or “buy” market share prior to recessions. Conservative use of funds goes out the window if credit is easily available.

As noted above, many business commentators refer back to recessions other than the last two to predict the future. The problem is that the farther back you go, the more different the socio-economic environments tend to be from today. This is why it is probably a good idea to look at what happened more recently when trying to extrapolate to now and the near future.

A Fed rate cut prior to a recession is not a good sign

Should a Fed rate cut at a period when the signs of an upcoming recession are pilling up be a source of concern for stock market investors? Any way you look at it, the answer is “yes”.

Human nature does not change that easily, and greed will not be checked unless things go really bad. When things go really bad, behavior changes. Individuals and organizations become more conservative regarding their finances.

Very likely a Fed rate cut prior to a recession will sustain or even exacerbate the types of behavior that are at the source of the recession.

Having said that, Fed rate cuts are important for the economic recovery and renewal that are normally seen after recessions.