Economic Signals Before Rate Cuts: Historical Lessons and Asset Reactions

Firstly, before each rate cut, the Federal Reserve typically observes signals of economic slowdown or weakening inflation. Reviewing these seven rate cut cycles, we find that the U.S. economy experienced a "hard landing" in three instances while achieving a "soft landing" in the other four. In the months following the first rate cut, the economy and employment may continue to weaken due to inertia, and inflation may not rebound quickly. Prior to rate cuts, assets such as U.S. Treasuries and gold generally benefit; however, after the cuts, the volatility risk of most asset prices may increase. After 2 to 3 months of adjustment, the easing of financial conditions and the expectation of economic recovery typically lead to optimistic performance in U.S. Treasuries and equities.

In light of the current economic environment, we believe that if there are no significant economic or financial market shocks in the future, this rate cut cycle is more likely to achieve a "soft landing." However, the initiation of this rate cut cycle came relatively late, and signals of weakening economic and employment markets are already quite evident. Therefore, after the rate cut, the economy and employment markets may still experience a period of inertia-driven decline. The trajectory of asset prices needs to be assessed in conjunction with the experiences of previous rate cut cycles, as well as macro factors such as the U.S. elections and Japan’s interest rate hikes.

We selected the seven rate cut cycles from 1982 to 2019 for analysis. Before 1982, the Federal Reserve's policy objectives were relatively complex, involving multiple indicators. Starting in 1982, the Federal Reserve gradually shifted to a policy primarily focused on the "federal funds target rate." This transition allowed the interest rate cycle to more accurately reflect the true state of the monetary cycle.

In these seven rate cut cycles, economic slowdown and weakening inflation provide a common backdrop, but each cycle also has its unique economic environment. For example, the rate cuts from 1984 to 1986 occurred against a backdrop of high fiscal deficits and a strong dollar; the cuts from 1989 to 1992 were due to the savings and loan crisis. In the period from 2001 to 2003, the bursting of the internet bubble led to economic weakness, prompting the Federal Reserve to implement rate cuts.

During these seven rate cut cycles, economic performance can be categorized into "hard landing" and "soft landing" scenarios. In a hard landing, the economy falls into recession, while in a soft landing, the economy slows down but does not reach recession levels. Preliminary data indicate certain patterns in U.S. economic indicators within six months before and after rate cuts. After a rate cut, production and consumption data typically weaken, and unemployment may face upward pressure; however, in a soft landing scenario, consumption growth may exhibit resilience.

Regarding inflation, the trends of PCE and core PCE inflation rates after rate cuts are often unstable, typically influenced by economic slowdown, leading to a decline in inflation expectations.

Asset prices exhibit different trends before and after rate cuts. U.S. Treasury yields generally decline after a rate cut, but in a soft landing scenario, a rebound may occur in the first two months. The movement of the dollar is more complex, as changes in the dollar index are not clearly evident in the 1 to 3 months following a rate cut. In terms of U.S. equities, there is typically a period of adjustment around the time of a rate cut, but in most cases, the market tends to recover and rise in the months that follow.

Gold tends to rise before rate cuts but often performs poorly afterward. Conversely, oil prices usually trend downwards following a rate cut, reflecting market concerns about economic weakness.

From historical experience, it is difficult to determine whether the U.S. economy can smoothly achieve a "soft landing" based solely on economic performance prior to rate cuts. If no significant shocks occur in the economy or financial markets, this rate cut cycle may achieve a soft landing. However, the current economic signals indicate strong signs of weakening, which could lead to inertia-driven downward performance in the economy after the rate cuts.

Additionally, asset price performance will be influenced by multiple factors, including the U.S. elections and Japan's monetary policy. Looking ahead, investors need to consider macroeconomic changes while focusing on the lessons from previous rate cut cycles to better navigate market trends.