1987 stock-market crash has lessons for traders convinced Fed will slash rates in 2024

1987 stock-market crash has lessons for traders convinced Fed will slash rates in 2024

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By William Watts

Fed ‘knows the warning’ of 1985-86: DataTrek queues

Without recession there is no problem? Investors appear confident that the Federal Reserve will embark on a historically aggressive round of interest rate cuts this year even as the economy avoids a hard landing.

Fed policymakers have seen this movie before and didn’t care about the ending, Nicholas Colas, co-founder of DataTrek Research, said in a Tuesday note. Investors may want to review the plot and adjust their expectations.

Fed funds futures traders are pricing in five to six rate cuts of a quarter percentage point each between now and the end of the year, in contrast to the Federal Reserve’s Summary of Economic Projections, also known as the “chart of points”, which calls for only three quarter-point rate cuts in 2024.

Economists have linked the price of the aggressive rate cut to expectations that the Federal Reserve will seek to keep real, or inflation-adjusted, rates stable if inflation continues to fall. The Federal Reserve is widely expected to leave the federal funds rate at 5.25%-5.50% when it concludes its two-day policy meeting on Wednesday, with the market pricing in a better than 50% chance of a cut. for the next meeting in March.

Related: Why Analysts Say the Fed Risks Clogging Financial Pipes Without a Policy Change

Meanwhile, stocks are back to all-time highs, with the S&P 500 SPX and the Dow Jones Industrial Average DJIA each posting their sixth record close of 2024 on Monday.

DataTrek took a look at past easing cycles to see how market expectations of a decline of at least 1.25 percentage points over the next year aligned with past easing cycles. As shown in the chart below, they found only one case in the last 44 years in which the Federal Reserve cut rates by 1.25 percentage points or more in a year when a recession was not underway or clearly visible. the view.

It happened in 1985-86. The Federal Reserve had raised the federal funds rate to 11.6% in August 1984 before beginning a mid-cycle easing program that brought it to 5.9% in October 1986.

Those cuts added fuel to a stock market rally, with the S&P 500 rising 31% in 1985, 18% in 1986 and another 31% through the end of September 1987, Colas noted.

Students of market history know what happened next. Black Monday, October 19, 1987, saw the S&P 500 fall more than 20% in a single day, while the Dow Jones fell 23%. The S&P 500 ended the fourth quarter of 1987 with a loss of 23%.

“The Fed knows the warning from 1985-1986 and, with absolute policy rates lower now, has even more reason to be cautious about the pace of rate cuts in 2024,” Colas wrote. “Without an imminent recession, there is simply no precedent for +1.0 point rate cuts this year.”

Furthermore, “stocks are already doing well enough that the risk of causing an unsustainable (1987-style) rally is very high,” he wrote.

Colas acknowledged the possibility that federal funds futures are “trying to tell us something” about the potential for a recession.

In fact, the apparent contradiction between federal funds and other markets has attracted a lot of attention. Strategists at Deutsche Bank noted earlier this month that the degree of cuts factored in by the market has almost always been accompanied by a recession, while the mid-1980s episode occurred after rates had elevated into highly restrictive territory when the Federal Reserve led by Paul Volcker squeezed inflation into submission.

On a chart: Why stock market bulls should be careful what they wish for on Fed rate cuts

Colas, however, doubts that the short-term rate market is sending out an economic warning signal.

Fed funds futures traders “are likely betting that the Fed will want to become less restrictive as inflation continues to decline,” Colas said. “According to the calculations, that’s fair enough. However, it doesn’t fit either the historical data or the institutional memory of the Federal Reserve.”

-William Watts

This content was created by MarketWatch, operated by Dow Jones & Co. MarketWatch is published independently of Dow Jones Newswires and The Wall Street Journal.

 

(END) Dow Jones News

02-03-24 0552ET

Copyright (c) 2024 Dow Jones & Company, Inc.

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