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Similar 'adjustments' by the Federal Reserve in the 1990s led to boom times for stocks

Key Points
  • This week's rate cut, the first in more than a decade, was reminiscent of the Fed's insurance easing episodes in the 1990s, Wall Street economists say.
  • The cuts in 1996 and 1998 managed to reignite the economy and drive the S&P 500 more than 20% higher within a year, CNBC analysis found.
  • Using Kensho, a hedge fund analytics tool, CNBC found that major stock averages skyrocketed after the initial rate cuts in the 1990s.
  • Stocks rebounded Thursday as traders reassessed their bearish outlook.
Jerome Powell, chairman of the U.S. Federal Reserve, speaks during a news conference following a Federal Open Market Committee (FOMC) meeting in Washington, D.C., on Wednesday, July 31, 2019.
Andrew Harrer | Bloomberg | Getty Images

Two words from Federal Reserve Chairman Jerome Powell — "midcycle adjustment" — may have briefly roiled financial markets, but the last two times the central bank adjusted its policy, the markets did just fine.

The first rate cut in more than a decade should be distinguished from "the beginning of a lengthy cutting cycle," the Fed chief said Wednesday as stocks cratered.

The move was aimed at insuring against downside risks, including trade tensions and slowing global growth. Wall Street economists say it was reminiscent of the Fed's insurance easing episodes in the 1990s. The cuts then managed to reignite the economy and drive the S&P 500 more than 20% higher within a year after the first move, CNBC analysis found.

In 1995-1996 and 1998, the Alan Greenspan-led Fed slashed rates three times, a total of 75 basis points, during both periods to combat an economic downturn and successfully prolong the expansion that ended up being the second longest in history. Those rate cuts were used as insurance against risks stemming from Mexican and Russian defaults and the collapse of hedge fund Long-Term Capital Management.

A CNBC analysis using Kensho, a hedge fund analytics tool, found that major stock averages skyrocketed following the start of the midcycle adjustments in the 1990s. The S&P 500 and the Dow Jones Industrial Average surged 20.5% and 23.5%, respectively, on average one year after the first cuts. The tech-heavy Nasdaq Composite soared a whopping 39%.

Safe haven Treasurys sold off in the meantime, with futures on the 10-year note losing more than 6% in the one year after the first cuts in 1995 and 1998. Gold performance was flat back then, whereas the greenback rose more than 5% on average.

"After other 'midcycle adjustments,' presumably referencing 1995 and 1998, the Fed was actually able to subsequently raise rates," Matthew Luzzetti, Deutsche Bank's chief U.S. economist said in a note. "[Powell's] point was more that such 'adjustments' have the potential to put the economy on a firmer footing, perhaps warranting higher rates in the future."

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The Fed lowered its benchmark rate by a quarter point Wednesday, the first rate cut by the central bank since December 2008. Powell cautioned against assuming that this week's cut is the beginning of the cycles that happened in the past.

Those comments from Powell caused the Dow to drop more than 300 points on Wednesday. But perhaps traders were reassessing the move on Thursday as stocks bounced back with the Dow up nearly 200 points.

"The Chair was trying to point to the insurance cutting episodes of 1995 and 1998, where the committee reduced the policy rate 75bp on two separate occasions," Michael Gapen, chief U.S. economist at Barclays, said in a note. "We read his comment that he does not see a prolonged rate cutting cycle was clearly related to recession risks and the likelihood the Fed has taken the first step that will end at the zero lower bound."

To be sure, there are still key differences between now and then that could diminish the impact of a midcycle adjustment. For one, the current expansion is now in the 11th year, the longest in U.S. history, which might need a little more stimulus than before.

"With the 1995 analogy of a midcycle cut in rates, people have to remember that it was just four years into an economic expansion, not 10 plus that we are in now," said Peter Boockvar, chief investment officer at Bleakley Advisory Group. "Hope springs eternal when faith in the Fed is as high as it was."