At its July policy meeting, the Federal Reserve cut short-term interest rates for the first time since the financial crisis. The decision came as no surprise to investors, with the futures markets predicting a 100% probability of a rate cut, with the odds also leaning towards a 25 basis point reduction.

Consistent with our expectations, the Fed lowered the federal funds rate by a quarter point to a target range of 2% to 2.25% − in an insurance cut aimed to keep a recession at bay. Federal Reserve Chairman Jerome Powell described the central bank’s decision as a consequence of slowing global growth, increased uncertainties from trade tensions, as well as muted inflation pressures. However, Mr. Powell suggested that the cut was a "mid-cycle adjustment" and not necessarily a signal of further cuts this year. Comments regarding the U.S. economy were generally optimistic noting a strong labor market and a healthy U.S. consumer as factors supporting the economy.

What Does the Fed’s Pivot Mean for the Markets?

U.S. equities fell and the Treasury yield curve flattened signaling disappointment that the Fed Chair did not telegraph more cuts. The S&P 500 finished down 1% in a choppy session. The two-year Treasury note rose to 1.87%, while the yield on the 10-year note settled back around 2.01%. This suggests that markets may have been a bit too aggressive in their rate cut expectations. Beyond the markets’ initial reaction, let’s take a look at what the Fed’s shift to a more accommodative stance means for the markets, using history as a guide.

Exhibit 1, based on data from Ned Davis Research, provides a historic look at prior Fed easing cycles and how the yield curve behaved both pre and post the initial cut. On average, there is a steepening of the yield curve following a cut. But, we believe that the closest blueprint for how the yield curve may react this time around, given the similarities in economic backdrop, is the Fed’s easing in 1998. At that time, the U.S. economy was generally on solid footing with a strong jobs market and muted inflation around 2%, but risks were emerging from abroad. The Russian debt crisis as well as the failure of Long- Term Capital Management, a major hedge fund, triggered massive risk aversion and an inversion of the Treasury yield curve.

Similar to 1998, the current partial yield curve inversion is due to the 10-year note falling as a result of a growth scare, rather than a signal of the ultimate end to this long economic expansion. We would, therefore, expect a modest steepening of the yield curve this time around as well, foreshadowing higher growth ahead, and stimulating growth in lending. Historically, equity markets tend to rally after an initial rate cut. This is particularly true in non-recessionary environments, which we believe we are in today, though investors should also recognize that much of the move higher in equities from this anticipated rate cut may have already transpired.

Investment Implications

The Fed’s policy adjustment should help support the economy and guard against downside risks. However, we expect that the central bank will remain data dependent especially given the improvement in recent economic data. Lower interest rates should encourage consumer spending and business investment, and help keep the U.S. economy chugging along at near-trend growth.

A backdrop of slow global growth, tame inflation and accommodative monetary policy by the Fed and other central banks argues in favor of maintaining equity exposure. Based on the strong year-to-date gains, equity returns may be more muted during the second half of the year and potentially more volatile. Based on a 12- to 18-month time horizon, we continue to maintain a neutral exposure to equities with a tilt toward U.S. large caps given their stronger fundamentals relative to other asset classes. We remain underweight fixed income and expect more subdued returns for the second half of 2019, as the majority of the rate move lower has most likely already occurred.

With this view, it’s also pertinent to examine the risks of this Fed cut. By reducing rates when the economy is on solid footing, the Fed may be potentially distorting asset prices. We will be watching signals like the yield curve as well as equity market multiples, but for now, we believe the Fed’s pivot should keep the expansion going.

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