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Where to Invest When the Fed Cuts Rates

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07/07/2019 | 09:44 am


By Amrith Ramkumar and Akane Otani



Stocks from New York to Brazil are racing to new highs. A key reason? Many believe the Federal Reserve is pivoting from raising interest rates to lowering them once again. Investors say that by lowering the cost of borrowing for consumers and businesses, rate cuts will spur spending and potentially prolong the longest bull market in history.



That is not a sure thing. History shows that stocks rallied after the Fed shifted from raising rates to lowering them in 1995 and 1998 but slumped for years after similar pivots in 2001 and 2007.



It is a similar story for oil prices, which many investors believe should rise if economic prospects are improving. Instead, crude has swung in both directions following past rate cuts.



As markets enter the second half of 2019, analysts and investors are closely watching the Fed, putting new emphasis on the central bank's meeting at the end of the month. If the Fed lowers rates, it would mark its first rate cut since 2008, when it began embracing easy money after the financial crisis. The Fed has raised interest rates nine times since December 2015, but they still remain well below precrisis levels.



The possible change of course comes at a time when other global central banks are shifting toward easing monetary policy, just after they had begun tentatively stepping away from postcrisis policies. Bets on lower rates helped push the S&P 500 and Dow industrials to fresh records last week, with indexes from the U.S. to Europe up 15% or more for the year.



Some analysts warn lower rates won't support stocks and other risky investments if the economy slows markedly, as many investors expect, or morphs into a recession.



"There's a lot of unfounded optimism that this recovery could be perpetually supported by fiscal and monetary policy," says Lindsey Piegza, chief economist at investment bank Stifel Nicolaus. "That's not indefinitely positive."



So do economic conditions today look more like they did in the market-fueled downturns of the '90s, or in the buildup to the housing crisis of 2007?



Some investors say current conditions are comparable to those surrounding Fed rate cuts in 1995 and 1998, when the central bank eased policy and a recession didn't follow. The unemployment rate is currently near its lowest level in almost five decades, and some analysts expect economic growth to slow from its first-quarter annual rate of 3.1% but remain stable.



Following a stronger-than-expected jobs report Friday, investors this week will parse minutes from the Fed's last meeting and figures on consumer prices to gauge the trajectory of U.S. growth. Stubbornly soft inflation has also given some analysts confidence that the Fed will lower rates later this month. Fed Chairman Jerome Powell's semiannual testimony to Congress will also be in focus this week.



Another factor keeping investors optimistic: Interest rates still remain relatively low compared with historical levels.



Following the best first half of the year for the S&P 500 since 1997, analysts are also weighing whether investors are too optimistic about the effects of rate cuts. Stocks have risen sharply in recent weeks in anticipation of a Fed rate cut later this month.



In 1995, they also rallied before the Fed lowered rates, only to continue their run. The 1998 rate cut was preceded by sharp stock-market declines as the meltdown of the hedge fund Long-Term Capital Management nearly brought down the financial system. Markets stabilized after the Fed cut rates.



In 2001, stocks also slid before the central bank cut rates as the tech-stock bubble burst.



Some analysts say protectionist trade policies are muddying the economic outlook to such an extent that past interest-rate cycles aren't comparable to the current period. An index measuring economic-policy uncertainty around the world created by professors at Northwestern University, Stanford University and the University of Chicago climbed near its highest level ever last month.



Even if the Fed lowers rates, some analysts are skeptical business and consumer spending will pick up if the U.S.-China trade fight remains unresolved. That could mean recent optimism driving stocks higher is misplaced, these analysts say.



"It's gone way too far," said Paul Christopher, head of global market strategy for Wells Fargo Investment Institute. "If the Fed cuts and people don't want to borrow because capital spending is frozen basically, what you end up with is a lot of money just sitting in the banks."



In one warning sign that the 10-year-old economic expansion could come to an end relatively soon, the gap between long- and short-term bond yields, known as the yield curve, turned negative earlier this year. A yield curve inversion has preceded the last several recessions, though they have often occurred well after the benchmark 10-year U.S. Treasury yield has dropped below the three-month yield in the past.



There is also the issue of timing investments around Fed rate cuts. An analysis of similar periods during which the Fed cut rates after previously raising them by Toronto money manager Gluskin Sheff & Associates showed the S&P 500 returned 22% on average in the year following the last interest-rate cut of each cycle.



The gap between the performance of stocks and the 10-year Treasury note was also much bigger following the final rate cut of each cycle than after the first time rates dropped, the analysis found. Gluskin Sheff also included rate-cut periods starting in 1984, 1987 and 1989.



"You want to resist the temptation at all costs to jump in after the first rate cut," says David Rosenberg, the firm's chief economist. "The stock market really differentiates itself the year after the last rate cut."



Write to Amrith Ramkumar at amrith.ramkumar@wsj.com and Akane Otani at akane.otani@wsj.com





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