Investors are giddy following the Federal Reserve’s big cut to interest rates.
The Fed slashed rates for the first time in four years on September 18.
They also handed the market a larger-than-expected 0.5% reduction rather than the 0.25% most anticipated.
The S&P 500 is jumping in response. It recently notched its 42nd record close for the year.
And investment strategists are even talking about an “everything rally”… where the entire stock market sees a melt-up.
Falling rates boost stocks because it costs less for companies to borrow. Lower rates also make stocks more attractive relative to parking your money in cash.
But a rosy outlook for the stock market hinges on one key scenario.
And that scenario is in jeopardy…
Can the Economy Stick the Landing?
When the Fed starts cutting interest rates, the stock market’s future comes down to a “soft” versus “hard” landing for the economy.
Historically, the Fed cuts interest rates after a tightening cycle of increasing rates.
It initially keeps rates high to slow the economy and lower inflation.
But the Fed often holds interest rates too high for too long. The damage done to the economy ultimately delivers a recession… the hard landing.
But sometimes the Fed acts quickly enough to avoid recession and simply slows the economy.
That’s the soft landing scenario.
And the difference between a soft and hard landing matters a lot to the stock market.
The chart below captures that difference…
The left shows how large-cap stocks have performed after a soft landing scenario. And the right shows stocks after a hard landing.
When the economy achieves a soft landing, large caps have gained an average of 18.1% in the 12-month period that follows.
But in a hard landing scenario, large caps fall -4.6% on average over the next year.
That’s why you should be paying attention to a key hard-landing signal…
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The Steepening Yield Curve
As the Fed cuts interest rates, follow the “yield curve” for clues on where the economy could be heading.
The yield curve is simply the difference between long- and short-term interest rates. Think of the 10-year minus the 2-year Treasury yield.
When the Fed pushes short-term interest rates above longer-term rates, the yield curve is said to be “inverted.”
But as the Fed lowers rates, the yield curve “uninverts” and starts to steepen by moving higher.
Historically, that’s a reliable recession signal. Take a look at the chart below.
The line represents the 10-year Treasury yield minus the 2-year yield. When the line is rising, the yield curve is steepening.
But look at what’s happened just before each of the past four recessions (the shaded areas).
The yield curve moves from below zero (the solid black line) to back above it ahead of each recession.
That’s because the Fed usually reduces rates at a quick pace only when signs emerge that the economy is stalling.
And that brings us back to present day…
When the Fed cut rates earlier this month, that helped push the yield curve back above zero again.
Time will tell, but that may mean a recession is around the corner.
So while it feels like an everything rally is taking hold, stay sharp…
This hard-landing signal suggests tough times ahead for the stock market.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict