- We quantify the impact on market sectors from three distinct but plausible scenarios for how the Federal Reserve might cut rates.
- If the Fed is successful and “gets things right,” both equites and bonds would rally, in our analysis.
- In the two other scenarios, “things go wrong” and bonds fall and equities rise (“too much easing, too early”) or bonds rise and equities fall (“too little, too late”).
A consensus has emerged that the Federal Reserve will cut rates in the coming months,1 but investors remain uncertain over the timing and magnitude of various potential rate-cutting campaigns and the impact they may have. We outline three scenarios 2 for how the Fed might ease rates and find that each leads to highly different outcomes under our stress test — with U.S.-equity returns ranging from -15% to 8% and Treasury returns from -4% to 4.5%. Let’s take a closer look at our three scenarios.
Insurance cuts: Threading the eye of the needle
Fed Chair Jerome Powell recently indicated that the Fed is committed to preventing an economic slowdown.3 While the U.S. economy is still relatively strong, Powell hinted that potential global risks may lead the Fed to take out “insurance” by cutting rates relatively early.
Under this scenario, which we assume is the best case, the market believes the Fed will prevent a significant slowdown in economic growth, without igniting inflation. Global confidence in the Fed grows. Markets respond warmly, risk appetite grows and the yield curve steepens. Equities and bonds rally, and the USD strengthens (see exhibit below). U.S. equity markets outperform non-U.S. markets, and U.S. credit spreads tighten more.
Too little, too late
In this scenario, the Fed is too slow to respond to a deteriorating economy, and the market believes the U.S. may enter a recession. U.S. equities decline substantially, while Treasury bonds gain as inflation expectations fall significantly. Global developed-market equities and bonds are affected less; we assume a more dovish monetary policy outside the U.S. Lower inflation expectations exert upward pressure on the dollar, and a diminishing risk appetite hurts credit spreads.
Too much, too early
In this scenario, markets perceive the rate cuts as over-aggressive — i.e., “too much, too early,” given the relatively strong state of the U.S. economy. The result is a “bear steepener,” where the yield curve steepens and yields on longer-maturity bonds rise, as the market prices in longer-term inflation. The U.S. equity market experiences small gains, while global equity markets outperform U.S. stocks. Global bonds experience smaller losses than U.S. bonds do. U.S. underperformance goes hand in hand with a weakening dollar.
Market impact of our three rate-cut scenarios4
|Insurance cut||Too little, too late||Too much, too early|
|Equity (return in USD)|
|MSCI USA Index||8%||-15%||3%|
|MSCI World ex USA Index||2%||-8%||8%|
|MSCI EM Index||2%||-15%||10%|
|Rates (change in basis points)|
|USD govt 2Y||-50bps||-60bps||35bps|
|USD govt 10Y||-30bps||-75bps||75bps|
|EUR govt 10Y||-15bps||-30bps||20bps|
|Credit spreads (change in percent)|
|U.S. credit spread||-12%||20%||-3%|
|DM credit spread||-6%||10%||-5%|
|Exchange rate (return)|
What would these scenarios mean for sector returns?
The three scenarios in our analysis show how Fed rate cuts may play out in divergent ways.5 The Fed is partly responding to changes in economic conditions, but its policymaking often also has a direct impact on the economy and sector returns.
Stress-test results for various market segments, from a local-currency perspective
Source: MSCI; IHS Markit. We applied the stress test to a hypothetical portfolio consisting of global equities and bonds. We proxied the hypothetical portfolios — in order of appearance in the exhibit — with the Markit iBoxx EUR Corporates Index, Markit iBoxx EUR Eurozone Index, Markit iBoxx GBP Gilts Index, Markit iBoxx Emerging Markets Sovereigns Quality Weighted Index, Markit iBoxx USD Liquid Investment Grade Index, Markit iBoxx USD Treasuries Index, MSCI USA IMI Index and MSCI ACWI IMI Index.
With returns expressed in terms of local currency, all sectors enjoy positive performance when the Fed “threads the eye of the needle” and successfully implements insurance cuts (see exhibit above), under our analysis. The positive correlation between bond and stock performance reflects the impact of “good” monetary policy. In the other two scenarios, either bonds rise and equities fall (“too little, too late”) or bonds fall and equities rally (“too much, too early”). In other words, negative correlation between stocks and bonds prevails, reflecting the impact of “bad” monetary policy.
Stress-test results for various market segments, from a USD perspective
Source: MSCI; IHS Markit.
When returns are expressed in USD terms, the results will also reflect changes in exchange rates (see exhibit above). The impact of exchange rates is most apparent in the case of bonds. In each of the scenarios, returns on non-U.S. bonds now move in the opposite direction of returns on U.S. bonds.
Markets will judge Fed policy
In the coming months, markets will scrutinize the Fed’s actions and react to the scenario path the Fed embarks upon. As our scenario analysis shows, markets’ reaction could translate to a wide range of sector returns.
1 See, for example: Wigglesworth, R. “Has the Federal Reserve fallen victim to bond market bullies?” Financial Times, July 13, 2019.
2 Our stress test starts with making assumptions about broad market aggregates as shown in the first exhibit. We then apply MSCI’s predictive stress-testing framework to propagate the main assumptions to all other risk factors impacting returns. The results shown in the second exhibit are generated based on this methodology, using MSCI's RiskMetrics® RiskManager®. Our assumptions of broad market aggregates have been informed by our analysis of historical data, but there is no historical time period that exactly corresponds to our assumptions. Our “insurance cut” scenario most closely approximates actual Fed cuts of 75 basis points, in both 1995 and 1998, which were followed by rallies in the bond and stock markets. Note that historical or backtested data frequently differs materially from actual scenarios. Additionally, past performance is not indicative of future results.
3 Powell, J.H. “Semiannual Monetary Policy Report to the Congress.” Federal Reserve, July 10, 2019.
5 In our analysis, the impact on returns from the Fed’s monetary policy is not measured at a specific point in time. Instead, our analysis aims to measure the cumulative impact up to the date when the market perceives that a specific scenario has been realized. This process may take months, as market participants analyze economic data and assess the Fed’s behavior.