Two Possible Outcomes Of A Fed Rate Cut, According To Merrill Lynch

by: FP Trading Desk

It’s 2:15 p.m. ET on Tuesday September 18 and the U.S. Federal Reserve has just cut the fed funds rate to 5.00% as the market expected. This follows the Fed’s unexpected cut to the discount rate (borrowing costs for bank loans) a month earlier, which was intended to ease the credit crunch.

The Fed hasn’t raised rates since June 2006, and hadn’t lowered them since June 2003, when it cut rates by 25 basis points to 1.00%.

So what do you do?

If the move came too late and the U.S. economy ends up slipping into a recession – as was the case in the early 1980s, early 1990s and again in 2001 – here’s what could happen according to Merrill Lynch North American economist David Rosenberg, who uses those three occasions as a guideline.

  • The fed cuts rates hard – by an average of 215 basis points in these first three months.

  • The greenback dips 0.8% and is down 1.6% after half a year.

  • Gold gains 11% and is up 17% after six months, but it is the only commodity to rally.

  • Volatility surges, with the VIX up an average of 28%.

  • Meanwhile, the S&P 500 is flat, the Russell 2000 falls 4.5% and the NASDAQ declines 5.3% in the first three months.

  • Early on, utilities, drug companies, food products and tobacco are good sectors to be in, while technology, industrials, consumer discretionary and the banks don’t do very well.

    While investors favoured bonds, stocks and cash (in that order) during these times of combined Fed easing and recession, between the third and six months after cuts begin, the optimal asset mix moves to more stocks and less bonds, since the equity market begins to discount the recovery, Mr. Rosenberg said.

    Finally, a year after the first cut, and after the economic downturn has passed (recessions average 10 months) stocks, cash and bonds (in that order) proved to work best, he added in a note to clients.

    So the main message is that in that critical first three months after the Fed cuts, how the dollar, bonds, volatility, commodities, stocks and sectors fare is dependant on whether the Fed moved in time.

    Given Merrill’s expectations that there is a 65% chance of a recession coming in the next year, and Mr. Rosenberg’s view that the easing is likely too late, high quality bonds and equities with earnings stability in times of economic downturn, as well as a focus on dividend yield, may be the way to go.

    However, if the Fed cut is just a financial event and does not become an economic one, Mr. Rosenberg says now is the time to chip away at the equity market – adding risk and liquidity as you go.