A trader walks on the trading floor at the New York Stock Exchange (NYSE) in Manhattan, New York City, US. (Reuters Photo)

By Lewis Krauskopf, Prinz Magtulis, Pasit Kongkunakornkul and Vineet Sachdev

NEW YORK- How stocks, bonds and the dollar perform after the Federal Reserve kicks off its rate-cutting cycle could depend on one factor more than most: the health of the US economy.

The Fed is expected to kick off a series of rate cuts on Wednesday, after raising borrowing costs to their highest level in nearly two decades. Markets are pricing in roughly 250 basis points of easing by the end of 2025, LSEG data showed.

For investors, a key question may be whether the Fed will cut rates in time to avert a potential economic slowdown.

The S&P 500 has slumped an average of 4 percent  in the six months following the first reduction of a rate-cutting cycle, if the economy was in a recession, data from Evercore ISI going back to 1970 showed. That compares to a 14 percent  gain for the S&P 500 when the Fed cut in a non-recessionary period. The index is up 18 percent  in 2024.

“If the economy is falling into recession, the rate cuts aren’t enough of a support to offset the move down in corporate profits and the high degree of uncertainty and lack of confidence,” said Keith Lerner, co-chief investment officer at Truist Advisory Services.

Treasuries have performed better during recessions, as investors seek the safety of US government bonds. The dollar, meanwhile, tends to rise less during a downturn, though its performance could depend on how the US economy fares in comparison with others.

Stocks

Recessions are typically called in hindsight by the National Bureau of Economic Research and for now, economists see little evidence that the US is currently experiencing one.

Those conditions bode well for the rally in US stocks, should they persist.

“Based on previous easing cycles, our expectation for aggressive rate cuts and no recession would be consistent with strong returns from US equities,” said James Reilly, senior market analyst at Capital Economics, in a report.

Still, worries over the economy have jolted asset prices in recent weeks.

Weakness in the US labor market has helped fuel sharp swings in the S&P 500, while global growth concerns are reflected in slumping commodity prices, with Brent crude oil trading near its lowest level since late 2021.

Uncertainty over whether growth is merely falling back to its long-term trend or showing signs of a more serious slowdown are reflected in futures markets, which in recent days have swung between pricing in a 25- or 50-basis-point cut on Wednesday.

The state of the economy is important for investors looking to gauge stock performance over the longer term, as well. The S&P 500 was down an average of nearly 12 percent  one year after an initial cut that took place during a recession, according to a study by Ryan Detrick, chief market strategist at Carson Group.

That compares to an average gain of 13 percent  following cuts that came in a non-recessionary period, when the reductions were to “normalize” policy, according to the data, which studies the last 10 easing cycles.

“The linchpin to the whole thing is that the economy avoids recession,” said Michael Arone, chief investment strategist for State Street Global Advisors.

Overall, the S&P 500 has been 6.6 percent  higher a year after the first rate cut of a cycle — about a percentage point less than its annual average since 1970, Evercore’s data found.

Among S&P 500 sectors, consumer staples and consumer discretionary had the best average performance, both rising around 14 percent  a year after the cut, while healthcare rose roughly 12 percent  and technology gained nearly 8 percent , according to Evercore.

Small caps, seen as highly sensitive to signs of an economic turnaround, also outperformed, with the Russell 2000 rising 7.4 percent  over the next year.

Treasuries

Bonds have been a rewarding bet for investors at the start of rate-cutting cycles. This time around, however, Treasuries have already seen a huge rally, and some investors believe they are unlikely to run much further unless the economy experiences a recession.

Treasury yields, which move inversely to bond prices, tend to fall alongside rates when the Fed eases monetary policy. The safe-haven reputation of US government bonds also makes them a popular destination during economic uncertainty. The Bloomberg US Treasury Index returned 6.9 percent  on a median basis 12 months after the first cut, Citi strategists found, but 2.3 percent  in “soft-landing” economic scenarios.

The yield on the benchmark 10-year Treasury has fallen about 20 basis points this year and stands near its lowest level since mid-2023.

Further gains in Treasuries may be less certain without a so-called economic hard landing that forces the Fed to cut rates further than anticipated, said Dirk Willer, Citi’s global head of macro and asset allocation strategy. – Reuters