Fed rate cut by 50 bps, and its impact on US equities

When the 10-year yield and the 2-year yield curve inverts and subsequently turns positive (i.e., the 10-year yield rises above the 2-year yield again), this is often considered a significant signal by financial markets. The curve’s inversion and its return to a positive slope combined with a 50 basis point interest rate cut creates a unique set of dynamics for the stock market, particularly the S&P 500.

Here’s how these factors interact and potentially affect the market:

  1. Yield Curve Returning Positive:
    • Recession Signal Diminishes: A yield curve inversion (when shorter-term yields are higher than longer-term ones) typically signals recession expectations. When the curve turns positive again, it may indicate that recession fears are abating, and expectations for future economic growth are improving. This could be seen as a positive signal for equities, including the S&P 500.
    • Rotation to Riskier Assets: As economic outlooks improve, investors may rotate out of safer assets like bonds and back into riskier assets like equities, potentially driving stock prices higher. This can be supportive of the market and increase demand for stocks in sectors like technology, consumer discretionary, and industrials.
  1. Effect of a 50 Basis Point Rate Cut:
    • Amplifies Positive Yield Curve Sentiment: A rate cut during or after the yield curve reverts to a positive slope can signal that the Federal Reserve is actively taking measures to stimulate the economy, which is typically bullish for equities. A rate cut reduces borrowing costs and may lead to higher corporate profits, boosting the S&P 500.
    • Boosts Equity Valuations: Lower interest rates decrease the cost of capital, and the discount rate used to value future corporate earnings declines, which raises stock valuations. In this scenario, the market would likely experience an upward adjustment.
  1. Combined Impact on the Market:
    • Potential for a Strong Rally: When these two events—yield curve reversion and a significant rate cut—occur together, they often signal a shift from recession fears to expectations of economic recovery. Historically, such combinations have been followed by strong equity market performance as risk appetite increases. For instance:
    • After the 2007-2008 financial crisis, the yield curve normalized and the Fed cut rates aggressively, which eventually led to a robust market recovery starting in 2009.
    • In 2019, following a brief yield curve inversion, the Fed implemented multiple rate cuts. As the yield curve normalized, the S&P 500 rose significantly.
    • Sector-Specific Gains: Sectors like technology, consumer discretionary, and industrials tend to benefit the most in such scenarios due to improved economic sentiment and lower financing costs. On the other hand, financials (banks in particular) may not benefit as much because lower rates reduce net interest margins.
  1. Quantifying the Impact:

Historically, after the yield curve reverts to a positive slope and the Federal Reserve cuts rates, the S&P 500 has generally seen significant gains. Although past performance doesn’t guarantee future results, some data points to potential gains in the range of 4-6% over the next few months, with more immediate gains in the 1.5-3% range in the month following these events.

However, the exact impact depends on market conditions, broader economic data, and global factors at the time of these events.

  1. Caveats:
    • Investor Expectations: If investors already anticipated both the yield curve reversion and rate cut, some of the positive market impact may be muted as it could already be priced into the market.
    • Broader Economic Risks: If the rate cut and yield curve reversion occur against a backdrop of significant economic weakness or global uncertainty, the market response could be less positive or even negative, as investors may focus more on underlying economic risks.

Conclusion:

When the yield curve turns positive after an inversion, and the Fed cuts interest rates by 50 basis points, this combination often leads to a positive reaction in the stock market, particularly the S&P 500. The immediate impact could be a 1.5-3% increase over the next month, with potential further upside in the subsequent months depending on broader economic and market conditions. The combined signal typically suggests improving economic prospects and can drive a risk-on sentiment in the market, benefiting equity prices.