Will The Fed’s Rate Cut Disrupt The Market’s Historical Seasonality?

Introduction

This trading week marked the beginning of fall, and many traders returned from vacation ready to place their bets again. Historically, September is the weakest month for the market, according to Seeking Alpha Premium data. Also, this seasonality appears to be statistically significant, with only a 30% win rate for this month for the S&P 500 ETF (NYSEARCA:SPY) (SP500) in the decade:

However, as the saying goes, past performance does not always predict future results. From a macro perspective, we currently have a very strong consumer demand in the US, as well as high hopes for AI and its effect on the market. Additionally, there’s a high likelihood that the Fed will soon begin to lower rates, which could theoretically provide a significant credit impulse to further stimulate economic growth.

Federal Reserve Chair Jerome Powell on Friday endorsed an imminent start to interest rate cuts, saying further cooling in the job market would be unwelcome and expressing confidence that inflation is within reach of the U.S. central bank’s 2% target.

[Reuters, emphasis added by the author]

So, will this September be different for markets? Let’s try to assess it.

Why Rate Cuts Matter?

First off, let’s get an idea of why rate cuts matter for future stock market performance. Based on Financial Theory 101, when central banks (in our case the Fed) lower interest rates, borrowing costs for businesses and consumers fall, which logically leads to an increase in borrowing for investment and consumption, which in turn stimulates economic activity. This is an axiom we should agree on.

With lower rates, businesses may afford to finance bigger projects, while consumers might find it more affordable to finance big-ticket items like homes and cars.

Another very important point that is not always taken into account is the possible depreciation of the dollar against other currencies. The fact is that the reduction in Fed rates is making it less profitable for foreign investors to borrow in dollars (because the yield has fallen) and they’re therefore starting to switch to more profitable assets denominated in other currencies. This shift in currency demand/supply leads to a weakening of the dollar, which is most easily seen in the recent dynamics of the US dollar index (DXY):

This is important because, according to BofA, around a third of the revenues of American companies on the S&P 500 list come from abroad.

This means that although they earn roughly the same amount there, they benefit from the exchange rate difference when converted into US dollars. Hence, it’s becoming easier for them to achieve a meaningful growth rate in sales, and if done properly through operating leverage, this top-line expansion may turn into a bigger growth in EPS.

So I think the importance of the Fed’s rate cut for the stock market cannot be overstated.

What’s Priced-In?

The challenge for the stock market today is that the expectation of an impending rate cut is already widely known among market participants. With U.S. inflation currently at 2.9% – very close to the Fed’s target and significantly lower than the levels seen back in 2022 – the likelihood of Jerome Powell raising rates is zero. Furthermore, he has indicated that the time for a rate cut has arrived – I provided the citation by Reuters at the very beginning of this article. So this information has led market participants to position themselves accordingly in anticipation of these changes.

The current rate range is 5.25%-5.5%, as all FOMC members voted to maintain it last time. However, on September 18, there will be another meeting where the market assigns a 61% probability to a 25 basis point rate cut. Meanwhile, the remaining 39% anticipate a more substantial 50 basis point reduction. So the likelihood of the current rate range remaining unchanged is effectively zero, based on market expectations.

I believe that the Fed’s rate cuts will only have a significant impact on the stock market if they go beyond the current consensus, i.e., run counter to market expectations. Given the systematic and steady approach of the Fed’s policy in recent months (my humble opinion), I don’t believe Jerome Powell will deviate from the consensus. My baseline scenario is therefore a gradual reduction of rates by 25 basis points – just as the consensus expects.

Risks To The Downside

When predicting how the Federal Reserve will act, and in macroeconomic forecasting in general, it’s crucial to consider the downside risks that surround us right away.

In my recent article on SPY, I mentioned that the market seems to be overlooking a significant risk: the potential resurgence of inflation due to the ongoing crisis in the Middle East. Only a few days have passed since my article was published, and the freight rates have managed to fall slightly since then, but the overall situation hasn’t improved yet with freight rates remaining very high.

Of course, this is just one component of the overall CPI basket, and as I mentioned in my previous article, most other components are indeed showing a downward trend. Recently, many have shifted their concerns from inflation to deflation as a risk factor. However, transportation costs significantly impact company pricing strategies – at some point, this may drive inflation upward, as strong consumer demand allows sellers to protect their margins by passing increased transportation costs onto the final prices of products.

Anyway, this is just one of the risks to consider. In my base case scenario, I don’t believe this risk will significantly influence the Fed’s short-term decisions on future rates. A rate reduction is set to occur soon, and unfortunately for those investing in the S&P 500 ETF today, this anticipated reduction is already factored into the current prices as far as I can see.

So Will September 2024 Break The Stats?

In response to the question of whether Jerome Powell’s interest rate decision will prevent the market decline typical of September, I believe that it won’t. This rate cut decision is already largely priced in – in order to significantly boost market growth, Powell would have to cut interest rates by 50 basis points. However, I don’t expect him to deviate from the consensus plan of a 25 basis point cut.

But I still haven’t addressed whether this September be different for the S&P 500 index, which started to fall sharply amid heightened volatility at the very start of this month:

Here I’d like to highlight a few significant factors that are not widely discussed.

First, according to data from Goldman Sachs [proprietary source], hedge funds have recently increased their gross leverage substantially.

Given the current market behavior, the likelihood of ‘degrossing’ – which typically involves reducing both long and short positions to decrease overall market exposure – is quite high. This is certainly not a promising sign for September 2024 to deviate from its usual seasonal patterns.

Second, the 2% decline in September we saw may be just the beginning, as the main pain for SPY usually comes in the latter half of the month:

Third, the buyback blackout period should begin in just 8 days. According to Goldman Sachs [proprietary source], while the demand for buybacks remains strong, it will start to decline as we approach the September 13 blackout date, when 50% of corporations will enter the blackout period. The bank estimates ~$6.62 billion in passive demand from these companies until the blackout starts. UBS [proprietary source] provides insightful charts illustrating the changes in buyback activity – unfortunately for the stock market, the changes are not promising a rebound this month.

Concluding Thoughts

To briefly answer the question posed in my article’s title: No, I don’t believe a rate cut will significantly boost the stock market and help September avoid its usual seasonality pattern, as Jerome Powell’s decision is already largely priced in. I don’t expect the Fed to take any actions beyond the current consensus. Additionally, several other factors suggest that this September will be as challenging for the markets as usual. The seasonal downward trend is likely to persist, especially with the potential reduction in hedge fund leverage (aka degrossing) and the upcoming buyback blackout period starting in a few days from now.

As my friend usually says in such cases, “I hope to be wrong if your book is long-only”. As I look beyond September/October, I’m leaving my “Hold” rating for SPY unchanged this time around.

Good luck with your investments!