Can Lower Rates Solve US Stocks & Bonds' 'High Valuation Risk'?
The Federal Reserve's first interest rate cut, a "big move," has once again ignited expectations that the US economy can avoid a recession, leading to further increases in the already high valuations of the US stock and bond markets.
A model that adjusts the S&P 500 index returns and 10-year Treasury yields based on inflation shows that current US stock and bond pricing levels are higher than the levels at the start of the Fed's previous 14 easing cycles (usually associated with recessions).
Along with the US stock market repeatedly hitting new historical highs, the total return of the S&P 500 index this year has exceeded 20%, indicating that regardless of how good the economic and policy news is this week, much of it has already been digested by risk assets.
Looking at the performance of major ETFs, US stocks and bonds are poised to achieve five consecutive months of gains, the longest synchronized upcycle since 2006.
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In addition, investors are pouring funds into riskier corporate bonds, betting that declining borrowing costs will enable debt-laden companies to refinance and extend maturities, thereby reducing default rates and supporting market valuations.
However, a significant interest rate cut may not be able to prevent investors from falling into a bear market.
Renowned journalist Spencer Jakab wrote in a report on Saturday that if the economy has already entered a recession, then "Federal Reserve Chairman Powell really cannot, as people imagine, prevent their investment portfolios from shrinking."
The initial reaction of the stock market to the interest rate cut on Wednesday was enthusiastic.
However, this is often proven to be an illusion - we still do not know the end of this grand drama.
Jakab cited a Goldman Sachs report pointing out that if the economy has fallen into a recession before the first interest rate cut, then the S&P 500 index is expected to fall by an average of 14% in the next year.
Taking the interest rate cut cycle of 2007 as an example, after the Fed's first interest rate cut, the US stock market went wild, and the Dow Jones index recorded the largest increase in more than four years, rising by 336 points, equivalent to about 1,000 points today.
Lehman Brothers' stock performed the best, soaring by 10%.
Coincidentally, both the first interest rate cut in 2007 and this one occurred on September 18, with the same initial federal funds rate and the same cut of 50 basis points.
But as is now known, the US stock market rose to its peak in the bull market only three weeks later, and panic plummeted in January 2008, and less than a year later, Lehman Brothers went bankrupt, becoming the largest bankruptcy case in American history.
By then, the Fed had cut interest rates six times, reducing the rate to 2%, the lowest level in nearly four years.
Within two months after the outbreak of the Lehman crisis, the Fed cut interest rates sharply three times, bringing the rate close to zero for the first time (technically 0%-0.25%).
Two months after the start of the interest rate cut cycle, market sentiment had become gloomy, but at that time, a survey of 54 economists showed that the possibility of the US economy falling into a recession in the next 12 months was only one-third.
Jakab wrote that the Federal Reserve "has no magic wand" to save the economy and stock market that has already fallen into trouble or is about to fall into trouble.
Interest rate cuts are definitely important for bond investors.
However, they may only (temporarily) weaken the emerging stock market slump and take a long time to penetrate companies and consumers.
In contrast, "the trajectory of economic growth is more likely to drive the stock market up than the speed of interest rate cuts," Goldman Sachs strategist David Kostin recently pointed out that if the economy has fallen into a recession before the first interest rate cut, then the S&P 500 index is expected to fall by an average of 14% in the next year.
If the economy has not fallen into a recession, the situation is exactly the opposite.
However, Jakab believes that there is currently no conclusive evidence that the US economy will fall into a recession soon, and stock market crashes are uncommon without a clear recession in the economy.
This helps to explain why the stock market can maintain a level close to the historical high, and the usual caution in the market is not obvious.
In addition, there is a misconception that the Fed's interest rate cuts are a reason to stay calm and continue to invest, which also supports market sentiment to some extent.
Jakab is not the only one worried that the Fed's significant interest rate cuts may be too late.
BlackRock researchers Amanda Lynam and Dominique Bly wrote in a recent report that due to the US monetary policy may continue to remain tight, market participants are also watching for signs of deterioration in fundamentals, especially floating rate bonds.
In addition, the two researchers pointed out that although CCC-rated corporate bonds have performed well, they are still under pressure overall.
Compared with interest expenses, the total revenue level of these companies is relatively low.
The borrowing costs of CCC bonds are still around 10%, and for some small companies, they have to refinance after the end of the loose monetary era, which puts them in a dilemma.
Even if interest rates fall, they face the risk of default.
J.P. Morgan analysts Eric Beinstein and Nathaniel Rosenbaum wrote in a research report last week that as long as the labor market releases any weak signals, this "will have a negative impact on the spread, because it will intensify people's concerns about a recession and reduce yields."
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