What to expect when you're expecting a rate cut

Jerome Powell, chairman of the U.S. Federal Reserve, speaks in Washington, D.C. on March 20, 2019.
Andrew Harrer | Bloomberg | Getty Images

A week of dovish fireworks out of the central banking community has just gone by with most of the world's leading central banks now guiding towards easing in light of downside risks to growth.

The latest meeting of the U.S. Federal Reserve showed eight out of 17 Federal Open Market Committee (FOMC) participants forecasting rate cuts this year while the interest rate market has gone even further, pricing in a little more than two 25 basis points cuts in 2019. Some analysts, such as UBS' Chief U.S. economist Seth Carpenter are even calling for a 50 basis points cut in July.

Subsequent debate has been ongoing on how long this easing cycle may last for.

There are certainly parallels between the environment today and 1995-1996. Back then, the Fed embarked on a series of three interest rate cuts (75 basis points) in total, the catalyst being low inflation rather than a recessionary economy, remarkably similar to today. The whole cycle lasted for seven months.

One ensuing question for investors then is how to trade this likely upcoming round of interest rate cuts in the face of weakening economic activity.

According to recent weekly data from Bank of America Merrill Lynch, inflows into U.S. equities accelerated to around $16.7bn, the highest inflow since March coinciding with both the S&P and Dow hitting new record all-time highs. Despite fixed income also posting strong gains as an asset class - with the yield for U.S. ten-year note dipping below 2% for the first time since November 2016 - inflows into government bonds and high grade credit actually dropped to $4bn from $9.8bn a week earlier.

The appetite then for stock markets remains strong. But what about performance?

Goldman Sachs equity analyst David Kostin analyzed equity returns during the past 35 years following the start of Fed cutting cycles. Their analysis show that the S&P index climbed a median of 2% and 14% during the three and 12-month periods following the start of a cycle. The performance was strongest during the 12 months following the cuts in July 1995 and September 1998 (+23% in both instances). In terms of sectors, Health Care and Consumer Staples sectors performed best while Technology posted the worst returns (-13% over 12 months).

For interest rate traders, the magnitude of the cutting cycle will determine where the most rewarding trades will be. Given that the interest rate curve is already pricing in more than two cuts for this year, in order to make money one has to expect three or more over the next six months.

However, not everyone is convinced. Maya Bhandari of Colombia Threadneedle told CNBC's Street Signs last week that they lightened their portfolios to fixed income markets because they think the interest rate market is pricing in too much easing

Given the performance last week, however, both bond and equity investors may still be in for a good run. The bond-buying trade seems to be back for now.