How Will Stocks React to a Fed Rate Cut? Here's the Guide to Sector Rotation

During the Federal Reserve's Jackson Hole meeting last week, Powell conveyed the message that 'the time has come' for the Fed to lower interest rates. After the meeting, the market has fully priced in a high probability of at least 69.3% that interest rates will be cut at least four times before the end of the year.

Since the policy interest rate of the U.S. Federal Reserve affects short-term rates, the latest interest rate quotes indicate that the inversion of U.S. Treasuries, which has lasted for more than two years, is finally coming to an end.

An inversion of the U.S. Treasury curve, or yield curve inversion, occurs when short-term interest rates (such as those on the 2-year Treasury notes) become higher than long-term interest rates (like those on the 10-year Treasury bonds).

Under normal circumstances, long-term bonds tend to have higher yields than short-term notes, reflecting the risks and uncertainties associated with the longer time horizon. However, when investors expect economic growth to slow down or a recession to occur, they might flock to long-term bonds as a safe haven. At the same time, short-term interest rates might rise due to actions by the central bank, such as the Federal Reserve, in trying to control inflation or economic overheating.

Conversely, the end of U.S. Treasury yield curve inversion may reflect the improvement in the economic outlook and monetary policy adjustments. However, it still does not necessarily mean that the risk has completely gone. The economic context and the reasons behind the change in the yield curve's shape should be carefully considered, as they could also signal other underlying economic shifts.

After studying the one-year performance post the uninversion of the yield curve, it was observed that value stocks tend to underperform growth stocks following the yield curve uninversion, as evidenced in the years 1998, 2007, and 2019. However, the year 2001 was an exception. During the burst of the internet bubble, growth stocks significantly underperformed value stocks. Thus, the question of whether growth or value stocks will outperform following a yield curve uninversion also largely depends on the valuation of growth stocks.

Historically, when the yield curve uninverts, the impact on different sectors has been variable, but the defensive value stocks, such as the S&P 500's consumer discretionary sector and the Russell 2000's health care sector, have shown the most consistent strong performance post-uninversion.

Looking at data since the mid-1990s, and comparing across the 11 Global Industry Classification Standard (GICS) sectors, large-cap consumer discretionary stocks in the S&P 500 have, on average, achieved the best performance relative to other sectors in the year following a yield curve inversion.

Technology and materials sectors have also performed well, with technology stocks outperforming the broader index more reliably, beating it in three out of four uninversions. Conversely, the financials and real estate sectors have generally performed the worst following a yield curve un-inversion.

In the Russell 2000, communications and discretionary sector were the strongest performers, while real estate and energy were the weakest. Hence, defensive sectors have typically performed better than cyclical ones.

In addition to the inversion of interest rates, the decline in the overall interest rate level in the United States will also have specific industry effects. Certain sectors could benefit more from rate cuts. For instance, sectors with high debt levels, like utilities or telecommunications, may benefit from reduced interest expenses.

The decline in U.S. interest rates will also reverse the situation of the strong U.S. dollar and affect global exchange rates. A weak dollar generally makes U.S. exports more competitive, benefiting companies with significant international sales. Conversely, it can increase the cost of imports and erode the net income of companies that heavily rely on raw materials imports.

Bloomberg's analyst Michael Casper noted in his latest report that, using monthly data going back to 1997 on an annual rolling basis, the US Dollar Index exhibits a more negative correlation with the large-cap value style than with growth, and the consumer discretionary sector shows the most negative correlation with the US dollar. This suggests that when the dollar weakens, consumer discretionary stocks are likely to rise.

In the meanwhile, falling interest rates often correspond to phases of economic contraction. Merrill Lynch's investment clock also shows a similar investment strategy, that is, when companies face the risk of recession, investors should focus on defensive industries.