US interest rates are going to fall, traders believe. Futures markets are pricing in a drop in the fed funds rate from its current 2.4 per cent to 1.5 per cent by this time next year. Equity investors should be aware, however, that this is not necessarily the good news you might think it is.
Certainly, cuts in the fed funds rate in the past have been associated with falling share prices. Big cuts in the funds rate in 2008-09 saw shares fall, while rises since 2015 have been accompanied by a bull market in equities.
This is no surprise. The funds rate tends to fall in bad times, when shares are falling. And if there is any causality involved it is falling share prices that cause cuts in the funds rate, not vice versa.
What should surprise and concern us, however, is something else. It’s that the positive correlation between annual changes in the funds rate and in the S&P 500 remains statistically significant even controlling for changes in current industrial production; in 10-year bond yields; and in industrial production in the following 12 months.
This tells us that the tendency for cuts in the funds rate to be associated with falls in share prices cannot be explained by the fact that rates are cut when the economy is doing badly; or by fears that it is about to do badly; or by investors becoming so nervous that they pile into bonds.
So, what does explain it? We can rule out the possibility that rate cuts are bad for equities; very few economists believe that.
Instead, there are two other possibilities.
One is that the Fed sometimes cuts rates not because the economy is faltering or even because its central forecast is that it will do so, but rather as insurance against the possibility of a recession. And because this possibility also worries stock markets, we can see shares and interest rates fall together even though current data suggests the economy is doing well.
There is, however, another simple explanation – one that should worry equity investors. It is simply that stock markets do at least sometimes discount events in advance. The efficient markets hypothesis is not always wrong. Something as big and obvious as the Fed’s intentions gets factored into prices. And when it does, the old adage holds: 'buy the rumour, sell the fact'.
Expectations of rate cuts are good for equities, but the reality of rate cuts is not.
Now, this is no cause for great alarm. Historic data tells us that selling on the facts is weak; controlling for other things since 1987 such as changes in output and bond yields, a one percentage point cut in the funds rate is associated with a fall of only just over 1 per cent in the S&P 500. This is entirely consistent with the possibility that the market will continue to rise as long as we continue to see non-inflationary growth.
Instead, the point is simple. Investors should not regard the prospect of rate cuts as a reason to buy US shares. There are other reasons, and better ones.
