Back to the Future: Applying 1987’s Stock Market Lessons to Today’s Fed Rate Speculations

The Fed is wary of a déjà vu from 1985-86 as investors anticipate aggressive interest rate cuts without the looming threat of a recession. Nicholas Colas from DataTrek Research suggests that revisiting history may prompt investors to adjust their expectations.

Market optimism is reflected in fed-funds futures traders pricing in five to six quarter-point rate cuts this year, in contrast to the Fed’s projection of only three cuts in 2024. This optimistic outlook is tied to expectations that the Fed will maintain real interest rates if inflation continues to decline.

While stock markets reach new highs, DataTrek’s analysis of past easing cycles points to a rare event in 1985-86 when the Fed cut rates by 1.25 percentage points during a non-recessionary period. Colas highlights that this led to a substantial stock market rally, ultimately culminating in the infamous Black Monday in 1987.

Colas underscores the Fed’s awareness of this cautionary tale and suggests that, given the current lower policy rates, the central bank has added reason to proceed cautiously in 2024. Without an imminent recession, substantial rate cuts this year lack historical precedent.

Acknowledging the possibility that fed-funds futures may signal a potential recession, Colas remains skeptical, attributing the market’s stance to a bet on the Fed becoming less restrictive as inflation declines. Despite the mathematical validity of this view, Colas contends that it diverges from historical data and the Fed’s institutional memory.