Cycle Trading: Changes in asset prices after interest rate cuts

Original title: "Cycle Trading: Changes in asset prices after the rate cut"

Original source: Cycle Trading

1. Restarting the easing cycle after four years

At 2:00 am on September 19th, Beijing time, the Federal Reserve announced a 50 basis point interest rate cut, and the target range of the federal funds rate was reduced from 5.25%-5.50% to 4.75%-5.0%, and a new round of interest rate cuts officially began. This 50bp interest rate cut is in line with the expectations of CME interest rate futures, but it exceeds the forecasts of many Wall Street investment banks. Historically, the first 50bp interest rate cut has only occurred in economic or market emergencies, such as the technology bubble in January 2001, the financial crisis in September 2007, and the COVID-19 pandemic in March 2020. Since a 50bp rate cut will make the market more worried about an economic "recession", Powell emphasized in his speech that he did not see any signs of recession, and as always, he used this method to hedge the market's recession concerns.

The Fed also gave a more hawkish dot plot, predicting two more rate cuts totaling 50bp this year, four rate cuts totaling 100bp in 2025, and two rate cuts totaling 50bp in 2026, with an overall rate cut of 250bp and an interest rate end point of 2.75-3%. The dot plot shows a relatively slow pace of rate cuts, and the path is slower than the CME interest rate futures trading of 2.75-3% in September 2025. At the same time, Powell emphasized that this round of 50bp rate cuts cannot be used as a new benchmark and linearly extrapolated. There is no fixed interest rate path set. It can be accelerated, slowed down, or even suspended. It will depend on the situation of each meeting, which explains the surge in US bond interest rates after the close to a certain extent.

In terms of economic forecasts, the Fed lowered its GDP growth forecast for this year from 2.1% to 2.0%, and significantly raised its unemployment rate forecast from 4.0% to 4.4%. And it lowered its PCE inflation forecast from 2.6 to 2.3%. The Fed's data and statements show that it has increased its confidence in curbing inflation, while paying more attention to employment. Overall, the Fed has played a big role in expectation management with a relatively large first rate cut and a relatively hawkish rate cut rhythm.

II. Interest rate cut cycles since the 1990s

June 1989 to September 1992 (recessionary rate cuts)

In the late 1980s, the rapid rise in US interest rates caused savings and loan banks to face the dilemma of short-term deposit rates being higher than long-term fixed loan rates, and the US Treasury yields were inverted. The "savings and loan crisis" broke out in the US financial industry, and a large number of banks and savings institutions went bankrupt. Combined with the external impact of the Gulf War, from August 1990 to March 1991, the US economy fell into a recession defined by the National Bureau of Economic Research (NBER), which lasted for 8 months. In June 1989, the Federal Reserve started a more than three-year interest rate cut cycle, with a cumulative interest rate cut of 681.25BP, and the upper limit of the policy interest rate dropped from 9.8125% to 3%.

July 1995 to January 1996 (preventive rate cut)

In 1995, the US economic growth slowed down and employment was sluggish. The Fed believed that although the economy had not yet entered a recession, the decline in some economic indicators might indicate the risk of a future economic downturn, and decided to start cutting interest rates to stimulate the economy and prevent recession. This rate cut began in July 1995, lasting 7 months, with three cumulative rate cuts, a total of 75BP, and the upper limit of the policy interest rate dropped from 6% to 5.25%. After that, the US economy achieved a "soft landing", and the employment and manufacturing PMI indicators that were weak before the rate cut rebounded. This round of interest rate cycle is also regarded as a typical case of "soft landing". On the other hand, the Fed's operation successfully avoided the "take-off" of inflation. During the rate cut, the PCE inflation rate hardly exceeded 2.3%, remaining relatively stable.

September to November 1998 (preventive rate cuts)

In the second half of 1997, the "Asian Financial Crisis" broke out. The economic recession in Asia led to weakened external demand, which affected the US commodity trade. The US economy remained stable overall, but the external environment was turbulent. The weakness of commodity trade put pressure on the US manufacturing industry and the US stock market adjusted. From July to August 1998, the SP 500 index adjusted for nearly two months, with the deepest drop of nearly 20%. The giant hedge fund Long-Term Capital Management (LTCM) was on the verge of bankruptcy. In order to prevent the impact of the crisis from further affecting the US economy, the Federal Reserve began to cut interest rates in September 1998. By November, it had cut interest rates three times, with a total of 75BP, and the upper limit of the policy interest rate was reduced from 5.5% to 4.75%.

January 2001 to June 2003 (Recessionary Rate Cuts)

In the late 1990s, the rapid development and popularization of Internet technology triggered excessive speculation, and the frenzy of irrational prosperity led to a large amount of funds flowing into Internet investment. From October 1999 to March 2000, the Nasdaq index rose as high as 88% in five months. From June 1999 to May 2000, the Federal Reserve raised interest rates 6 times, a total of 275BP, to cope with the overheating of the economy. In March 2000, the Nasdaq index fell rapidly after reaching its peak, the Internet bubble gradually burst, a large number of Internet companies went bankrupt, and the economy fell into recession. On January 3, 2001, the Federal Reserve announced a 50BP interest rate cut, and then cut interest rates 13 times, a total of 550BP, and the upper limit of the policy interest rate dropped from 6.5% to 1.0%.

September 2007 to December 2008 (Recession-style rate cuts)

In 2007, the US subprime mortgage crisis broke out and further spread to other markets such as bonds and stocks, and the US economic situation took a sharp turn. On September 18, the Federal Reserve lowered the federal funds target rate by 50BP to 4.75%, and then cut interest rates 10 times in succession. By the end of 2008, the interest rate had dropped by 550BP to 0.25%. The rate cut was still not enough to cope with the severe economic situation. The Federal Reserve introduced quantitative easing (QE) for the first time, using unconventional monetary policy tools such as large-scale purchases of US Treasury bonds and mortgage-backed securities to lower long-term interest rates, stimulate the economy and inject liquidity into the market.

August to October 2019 (preventive rate cut)

In 2019, the US economy and job market were generally stable, but under the influence of factors such as geopolitical conflicts and Sino-US trade frictions, US external demand weakened, while domestic demand also showed a slowing trend, and the inflation rate was below 2%. In the first half of 2019, the PCE inflation rate remained at 1.4-1.6%, and the core PCE inflation rate dropped from 1.9% at the beginning of the year to 1.6% in March-May.

On July 31, 2019, the Federal Reserve announced a 25BP interest rate cut to 2.25%, saying that the US economy grew moderately and the job market was stable, but the overall and core inflation rates were both below 2%, aiming to prevent economic slowdown, especially considering the background of tense trade situation and slowing global growth. Before the global outbreak in 2020, the U.S. economy was operating stably as a whole, with indicators such as manufacturing PMI and core PCE rebounding. From August to October 2019, the Federal Reserve cut interest rates three times in a row, a total of 75BP, and the upper limit of the policy interest rate dropped from 2.5% to 1.75%.

March 2020 (Recessionary Rate Cut)

In 2020, the COVID-19 pandemic spread across the globe. In March 2020, the Federal Open Market Committee made two sharp rate cuts at an unscheduled emergency meeting, restoring the federal funds target rate range to 0 to 0.25%.

III. Asset Prices in Rate Cut Cycles

The change in asset prices after the rate cut has a great relationship with whether the macroeconomic environment at that time is in recession. It is believed that the current US economic data does not support the conclusion of recession. Under the premise of a soft landing of the US economy, more attention should be paid to the asset price trend in the period of 19 to 20 years, which is closer to the present time, during the preventive rate cuts.

U.S. Treasuries

Before and after the rate cut, U.S. Treasuries were on an overall upward trend. The rise before the rate cut was more certain and larger. The average frequency of increase in the 1, 3, and 6 months before the rate cut was 100%, and it decreased after the rate cut. At the same time, the average increase in the 1, 3, and 6 months before the rate cut was 13.7%, 22%, and 20.2%, and 12.2%, 7.1%, and 4.6% after the rate cut. It can be clearly seen that the market priced in in advance. The volatility intensified about a month before and after the rate cut. In the later period of the rate cut, due to different economic recovery situations, the interest rate trends in different periods diverged.

Gold

Similar to U.S. Treasuries, overall, the probability and magnitude of gold's rise before the rate cut are greater. Benefiting from the risk aversion demand in critical situations, the correlation between the trend of gold and whether there is a "soft landing" is relatively unclear. From a trading perspective, the optimal trading time for assets on the denominator side is before the interest rate cut. Due to the full inclusion of expectations and the limited interest rate cut, after the interest rate cut is realized, more attention can be paid to the assets on the numerator side that benefit from the interest rate cut.

Based on the gold ETF dividing line, the correlation between gold prices and interest rate cuts was not clear before the 21st century. In 2004, the US SEC approved the first globally traded gold ETF. The rise of gold ETFs promoted a surge in demand for gold investment, attracted a large number of retail investors and institutional investors, and the continuous inflow of funds provided a strong impetus for the rise in gold prices. Until it peaked in 2011, this round of rising cycle lasted for 7 years. During this period, the Federal Reserve experienced a sharp interest rate hike from 2004 to 2006 and a sharp interest rate cut from 2007 to 2008. Gold maintained an overall upward trend. Excluding the impact of gold ETFs, the only meaningful interest rate cut cycle that can be used as a reference is 2019. In the short term, during the interest rate cut cycle from August to October 2019, gold rose sharply after the first interest rate cut, and then fluctuated and fell back in the next two months. In the long term, gold still showed an upward trend after the interest rate cut.

Federal Reserve Interest Rate Cycle and Gold Price

Nasdaq

The performance of the Nasdaq in a recessionary interest rate cut depends on the fundamental repair. In a recessionary interest rate cut cycle, the Nasdaq as a whole mostly shows a decline, except for a 28% increase in the ultra-long interest rate cut cycle in 1989, and a decline of 38.8%, 40% and 20.5% in the interest rate cut cycles in 2001, 2007 and 2020 respectively. The short-term performance of the Fed's first preventive interest rate cut in different years varies, but in the long run, it has all risen. Intuitively understood preventive interest rate cuts can often have a positive effect on the economy, reverse signs of weakness, and drive the stock market up. Therefore, the key to judging the trend of the Nasdaq index lies in the grasp of the recession. In the interest rate cuts in 2019, the Nasdaq fell back after the first and second rate cuts, and showed an overall oscillating trend within three months of the rate cuts, and started to rise around the third rate cut.

BTC

In the interest rate cut cycle in 2019, BTC prices rose briefly after the first rate cut, and then opened a downward channel as a whole. The overall retracement from the top lasted 175 days, and the retracement was about 50% (excluding the impact of the subsequent epidemic). What is different from the previous rate cut cycle is that due to the swing in the expectations of rate cuts, BTC's retracement this year came earlier. After the high point in March this year, BTC has been oscillating and retracement for a total of 189 days, with a maximum retracement of about 33%. From the historical experience, the long-term bullish market outlook is likely to fluctuate or pullback in the short term, but the intensity and duration of the pullback will be smaller and shorter than in 2019.

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