Source: Wall Street See

Prior to the announcement of the Federal Reserve's interest rate decision, Bank of America's chief strategist, Michael Hartnett, issued a warning that a substantial rate cut could lead to a resurgence of inflation risks, and gold would be the best hedge against inflation in 2025. Looking at the market performance after the Federal Reserve's 50 basis point rate cut on Wednesday, gold is indeed one of the best performing assets, in addition to Bitcoin.

However, almost all assets, except for the 10-year U.S. Treasury bonds, are rising, which is almost the opposite of the traditional performance of "safe-haven" assets in a relaxed financial environment. The last time the Federal Reserve cut rates by 50 basis points, the market fell was during the outbreak of the financial crisis in October 2008.

In the latest Flow Show report, '50 basis point rate cut for small businesses', Hartnett explains the reason for this exuberant rise. When there is no panic (at least not yet), Wall Street loves the "panic rate cut" the most. At the same time, the Federal Reserve hopes to cut rates by 50 basis points so that real interest rates can decline from the highest level of this century, preventing job cuts in the recession-hit small business sector.

"Panic rate cut" or "soft rate cut"?

After announcing the rate cut, Federal Reserve Chairman Jerome Powell said the word "re-calibrate" ten times during the monetary policy press conference, indicating that the Fed is adjusting its monetary policy stance to fit the current economic conditions. Hartnett says that Wall Street's interpretation of this is that the Federal Reserve may be "ahead of the curve" and expects a 250 basis point rate cut by the end of 2025, which could lead to a 20-25% growth in earnings per share (EPS) of U.S. stocks.

However, Powell seemed somewhat ambiguous when explaining whether the Fed is "behind the curve". Note that the last time the Fed cut rates by 50 basis points with such a low credit spread was in January 1981, and the U.S. stock market reached its all-time high in April 1986.

Historical data shows that after the first interest rate cut by the Federal Reserve, inflows into money market funds usually last for 9 months. However, the aggressive easing policies in 2009 and 2020 led to a sharp decline in funds, which could be a signal of market bubble risk. Recently, there has been a large-scale outflow of funds from global stock markets, especially the US stock market, while the bond market continues to attract inflows, particularly investment-grade and high-yield bonds.

The report shows that the Federal Reserve has conducted 12 rounds of interest rate cuts since 1970, which can be classified into three categories based on the first rate cut and market reaction:

"Soft Rate Cut": After the Federal Reserve cuts interest rates, the US enters a "soft landing", such as in 1984, 1995, and 2019...which benefits stocks and bonds. The S&P 500 index rose 10% within 6 months after the first rate cut, and the yield on 10-year US Treasury bonds fell by 56 basis points.

"Hard Rate Cut": After the Federal Reserve cuts interest rates, the US enters a "hard landing", such as in 1973, 1974, 1980, 1981, 1989, 2001, 2007...which is not favorable for stocks. The S&P 500 index fell by 6% within 3 months, but it is beneficial for bonds as the yield on 10-year US Treasury bonds fell by 38 basis points within 6 months.

"Panic Rate Cut": The Federal Reserve cuts interest rates due to Wall Street crashes/credit events, such as in 1987 and 1998...which is very risky. The S&P 500 index rose 20% within 6 months after the first rate cut.

Hartnett believes that the market's reaction to a 50 basis point interest rate cut by the Federal Reserve seems to follow the script of a "Soft Rate Cut" or a "Panic Rate Cut".

Anticipating that the Federal Reserve can prevent the number of new jobs from falling below 0.1 million and the default rate from rising, Wall Street has conducted a classic "Fed Turn" trading, as seen in the asset boom when the Federal Reserve reduced interest rates from 9% to 4% from 1975 to 1976, laying the foundation for a more intense inflation surge in the future.

"Bubble Risk" reemerges, are bonds and gold the best hedge tools?

Hartnett warns that the current US stocks and credit markets are digesting the expected 250 basis point interest rate cut by the Federal Reserve by the end of 2025, and the anticipated 18% earnings growth of the S&P 500 index components. The 'risk is not good,' so investors are forced to chase the upward trend. 'Bubble risk' is making a comeback, so it is advisable to buy bonds and gold on dips.

If job growth remains between 0.125 million and 0.175 million, it would indicate a 'soft landing' for the US. Hartnett believes that stocks and commodities outside of the US are better investment targets, the latter being one of the common means to hedge against inflation.

Finally, here are the best market 'indicators' that Hartnett uses to determine whether a hard landing, soft landing, or no landing is on the horizon:

Soft Landing: If the price of private equity ETF (PSP) exceeds $70, it may indicate that the market expects a significant interest rate cut by the Federal Reserve to be beneficial to the macro economy.

No Landing: If the prices of certain ETFs, such as SPDR S&P Global Natural Resources ETF (GNR), SPDR S&P Regional Banking ETF (KRE), and iShares MSCI Emerging Markets ETF (EEM), exceed $60 and $45 respectively, it may suggest that Wall Street's inflation expectations will spread to a broader economic sector, namely 'Main Street.'

Hard Landing: If the yield on 30-year US Treasury bonds remains below 3.75% even in the face of debt, deficits, political uncertainty, and inflation, it may indicate that the market expects an economic recession.

Editor / jayden