Wall Street ready for pause in Fed rate cuts

By Adam Shell, USA TODAY
NEW YORK — A pause in interest rate cuts by the nation's central bank could prove to be refreshing for the stock market.
Investors who once clamored for rate cuts to stabilize a slowing economy and financial system on the verge of a meltdown now are calling for a halt to the Federal Reserve's easing cycle. Wall Street is now of the mind that further cuts would do more harm than good.

The 3.25 percentage-point reduction in the fed funds rate to 2% since September has restored a sense of calm to markets.

But the cheap money has also eroded the value of the U.S. dollar and contributed to an alarming rise in the price of gasoline and food, putting pressure on cash-strapped consumers.

In a statement last week, the Fed hinted that its campaign to lower borrowing costs may be near an end, saying the "uncertainty about the inflation outlook remains high." But it's not just the hope that the Fed can control inflation that has Wall Street wanting an end to the rate-cutting program.

There is a financial motive, as well: Stocks have historically performed very well during "pause periods," when the Fed has stopped lowering interest rates, an analysis by Bespoke Investment Group found.

In the past 50 years, the benchmark Standard & Poor's 500-stock index has rallied 12.3%, on average, in the period from the last rate cut in an easing cycle to the first rate increase. (The S&P is up 2% since the Fed cut on Wednesday, and a total rise of 12.3% would put it just shy of a new high.) The average duration of the Fed's pause in those 12 interest rate cycles in that period was 329 days, or almost 11 months.

Stocks rise when the Fed starts to wean the market off cheap money, because the pause:

•Signals the outlook is brightening. If the Fed no longer sees the need to provide monetary stimulus, it suggests that it is confident the economy is on the comeback trail, says Paul Hickey, Bespoke's chief investment guru.

•Shows lag effect is kicking in. It usually takes six months to a year for the benefits of rate cuts to cycle their way through the economy. Hickey says that when the Fed pauses, it often coincides with signs that the cuts are working.

While those explanations have proved true in the past, circumstances surrounding the Fed's hoped-for pause now may suggest a different outcome for stocks, says Christopher Orndorff, managing principal at money management firm Payden & Rygel.

"Historically, stocks go up because the market assumes the Fed has done their job," says Orndorff. This time, a pause is expected, "not because things are rosy again in the economy, but because inflation is higher than they would like."

Orndorff says the Fed would be in a tough spot if the economy weakens more, because if it is forced to cut again, it could fan inflation. The Fed meets again on interest rates at the end of June.