In 2024, the Federal Reserve’s decision to lower interest rates has reignited an age-old discussion among investors: do such easing cycles prolong economic expansions, or do they foreshadow potential recessions? With inflation persisting as a concern, the Fed’s upcoming actions could significantly impact investment portfolios. By examining historical trends, we can glean valuable lessons that help navigate the current late-cycle economic landscape.
This analysis draws on the insights of renowned economist Milton Friedman, who famously noted the long and variable lags of monetary policy. We will delve into past rate cycles to understand their effects on market dynamics, including yield curves and investment styles, offering guidance for investors today.
Examining Rate Cut Cycles
Figure 1 illustrates the performance of equity markets during three distinct intervals following the Fed’s initial rate cut: the first year, the second year, and the third year. Generally, returns during these periods are positive; however, the variability across cycles suggests that outcomes are heavily influenced by the specific macroeconomic context in which each easing occurs.
Analyzing Historical Performance
Historical analysis reveals that during 12 different easing cycles, the Fed initiated rate cuts after the equity markets had already reached their peaks in most instances. In fact, in ten out of these twelve cases, the timing of the Fed’s response indicates a lag in policy adjustment. Additionally, the National Bureau of Economic Research (NBER) typically identifies recessions with a delay of several months, further complicating the matter. Since the tumultuous monetary climate of the 1970s, the Fed has increasingly enacted rate cuts prior to formally recognizing recessions.
Figure 2 displays the historical correlation between the Fed’s rate-cutting cycles, recessions, and bear markets. This exploration reveals that while rate cuts tend to precede or coincide with economic downturns, the specific conditions and market sentiment at the time can lead to unpredictable outcomes.
Understanding Rate Hike Cycles
Between 1965 and 2024, there have been twelve distinct cycles of rate increases, with eight of these leading to recessions. Notably, ten of them were preceded by yield curve inversions, and nine coincided with bear markets, as depicted in Figure 4. The median duration of these rate-hiking phases has been around 18 months, with increases in the federal funds rate averaging 3.75%.
Impact of Rate Hikes on Market Dynamics
Throughout most rate-hiking cycles, the Fed maintained its tightening strategy even after market peaks were reached. This reinforces the notion that bull markets do not simply age out; rather, they are often brought to an end by the actions of the Fed. Although this aggressive approach can lead to economic contraction, there are instances where the Fed has proactively cut rates in an attempt to cushion the economy before recessions hit.
For instance, in five of the eight recessions since 1965, the Fed began reducing interest rates before the onset of economic decline, a strategy aimed at mitigating recessionary impacts. However, the effectiveness of these preemptive cuts is not guaranteed, as they often fail to avert downturns once broader economic momentum begins to wane.
Yield Curve Inversions and Their Implications
The relationship between yield curve inversions and economic cycles is another crucial element for investors to consider. Figure 5 illustrates that out of the twelve tightening cycles, ten were accompanied by yield curve inversions, with eight leading to recessions. Historically, these inversions have been reliable indicators of impending recessive phases in the economy.
Interestingly, while some cycles have experienced inversions without subsequent recessions, such as those in 1984 and 1995, others have shown immediate downturns following inversions. The complex interplay between economic factors makes it challenging to predict market behaviors based solely on these indicators.
Conclusion: Insights for Today’s Investors
This analysis draws on the insights of renowned economist Milton Friedman, who famously noted the long and variable lags of monetary policy. We will delve into past rate cycles to understand their effects on market dynamics, including yield curves and investment styles, offering guidance for investors today.0
This analysis draws on the insights of renowned economist Milton Friedman, who famously noted the long and variable lags of monetary policy. We will delve into past rate cycles to understand their effects on market dynamics, including yield curves and investment styles, offering guidance for investors today.1