Changes in Interest Rates have predicted all three major economic crises of the last twenty-five years.
The Federal Reserve, the US central bank, raised its policy interest rates from 0.25 to 5.25 per cent between March 2022 and July 2023. The rates were kept unchanged for the next fourteen months. In its latest move, the Fed cut its policy interest rate by 50 basis points to 5.00 per cent in September 2024. This pattern of rate hikes followed by a rate pause and then rate cuts is not new. The latest occurrence of the pattern is the fourth one in the past twenty-five years. The previous episodes happened between 1999 and 2001, 2004 and 2007, and 2018 and 2020. The pattern has an ominous nature because, sooner or later, a crisis has always accompanied the first rate cut that follows a period of pause in rate hikes. The aftereffects of the crisis were a significant decline in stock prices and an economic downturn.
The 1999 – 2001 episode culminated in the dot-com bubble burst, the 2004 – 2007 episode culminated in the global financial crisis, and the 2018 – 2020 episode, though partly a health crisis, culminated in the COVID-19 pandemic crisis. A sharp drop in stock prices and severe economic downturns accompanied each crisis.
The 1999 – 2001 episode
The Federal Reserve increased its policy interest rate from 4.75 to 6.50 per cent in the one year between June 1999 and May 2000. The stock market was in an exciting bull market then, precipitated by the mania around internet stocks. Stock prices gained during the rate hike period and continued to rise even after rate hikes were paused in May 2000.
Prices finally peaked in August 2000 and began falling, commencing a bear market that lasted for two and a half years. During the period, US stock prices declined by 50 per cent and bottomed by March 2003. The US economy experienced a severe economic slowdown during the 2000 – 2003 period. The annual US GDP growth, which had ranged from 4 – 5 per cent until 2000, declined from Q4-2000 onwards to 1 – 2 per cent and recovered towards 4 per cent only by Q4-2003.
Responding to the economic downturn, the Federal Reserve aggressively reduced policy interest rates from 6.50 to 1.00 per cent between January 2001 and July 2003.
In this episode, the markets peaked in August 2000, four months before the Fed’s first rate cut decision (around January 2001). However, a major decline in stock prices began only around the time of the first rate cut.
The 2004 – 2007 episode
Convinced of the economic recovery, the Fed started raising interest rates from June 2004 onwards. Stock prices recovered from the bottom of March 2003 and were up 30 per cent by the time the Fed began raising rates. The rates were raised from 1.00 to 5.25 per cent in one year. Stock prices remained unchanged over the course of the year.
The Fed kept rates unchanged and higher at 5.25 per cent for the next two years (until September 2007), during which stock prices rose 27 per cent.
The Fed cut rates by 50 basis points in September 2007, followed by another 25 basis points in October 2007. Two rate cuts of 25 basis points were made in December 2007. By the end of the year, interest rates had dropped to 4.25 per cent. Meanwhile, stock prices peaked in October 2007 and remained mostly unchanged for the rest of 2007.
However, the entire global financial system experienced acute distress in January 2008 (acute distress is an understatement; financial Armageddon would be the most suitable word to describe the 2008 economic situation). Stock prices crashed around the world, announcing the onset of the global financial crisis of 2008-2009. Central banks kept cutting interest rates steeply, and the US policy interest rates reached 0.25 per cent by the end of 2008.
The impact of the crisis on the economy was more severe this time. In Q3-2008, US GDP growth declined to 0.3 per cent; in Q4-2008, GDP fell by 2.5 per cent; in Q1-2009, it declined by 3.2 per cent; in Q2-2009, GDP declined by 4.0 per cent; in Q3-2009, for the fourth consecutive quarter, GDP fell by 3.1 per cent. In Q4-2009, GDP grew marginally by 0.1 per cent; finally, the gradual recovery began from Q1-2010 onwards.
Stock prices were down 50 per cent from the peak of October 2007 when they bottomed out in March 2009. Unlike the previous episode (2000-2003) when the Fed rate cut came four months after markets peaked, here, they almost coincide.
But what happened after the first rate cuts in both cases were identical: massive fall in stock prices and severe economic downturns that lasted between one and two years.
The 2018 – 2020 episode
This episode involves two quarters of economic output growth slowdown and three consecutive quarters of economic output decline. At the downturn’s trough, the unemployment rate reached double digits.
Between November 2015 and December 2018, the Federal Reserve raised its policy interest rates from 0.25 per cent to 2.5 per cent. However, the Fed had to reverse course almost seven months after the last rate hike in December 2018 as the adverse effects of the rate hikes on the economy became evident. The Fed reduced the policy interest rate by 75 basis points in 2019.
Soon, the COVID-19 pandemic and the associated nationwide lockdown occurred. The Fed responded to the crisis by cutting rates steeply, so that, by the end of March 2020, rates were near zero at 0.25 per cent. Stock prices declined 25 per cent in the first three months of 2020 but recovered fully from the fall over the next three months.
In this most recent episode, the economic downturn and the stock price crash ensued almost fourteen months after the Fed started cutting rates.
The three episodes differ mainly in two ways:
- The duration of the downturn and recovery, and
- the time difference between the first rate cut and the onset of the crisis.
But the similarities between the three episodes are the significant takeaways:
- A crisis accompanied the first rate cut that followed an extended rate hike pause.
- A significant decline in stock prices and an economic downturn are the aftereffects of the crisis.
- Both the aftereffects are inevitable, despite largesse from governments and central bankers.
If a crisis had accompanied all three times rates were first cut after a long pause in rate hikes over the past twenty-five years, the chances of a crisis accompanying the September 2024 rate cut, which comes after an extended rate hike pause, are highly likely. A crisis usually arrives when it is the least expected. A market at all-time highs, highly positive market sentiments, an exciting IPO market, an optimistic economic outlook, and excessive retail participation in the stock market are some features present just before things turn for the bad. All these features are evident in the current markets. But there are no thresholds to these excesses. Higher prices can go even higher, and exciting markets can get more exciting. The exact point of the revert is hard to predict. I have been warning about a market crisis for over a year. However, prices kept rising – proving me wrong.
Confirmation bias is a human fallibility. It states that once we have formed a belief or opinion, we tend to accept only new information that agrees with our beliefs or opinions and reject all new information that disagrees with them. In my November 2023 market outlook, I first suggested the near-term possibility of a crisis-like event in the markets. I discussed the same likely scenario in all nine market outlooks that followed. There is a possibility that confirmation bias was at play here. I concluded that markets are headed for a crisis in November 2023. In all the market outlooks that followed, I might have been biased to look only at information that agreed with the belief formed in November 2023 and disregard all information that disagreed with it.
Things seem so convoluted and amorphous now. I never made it so. That’s how things always are, particularly when it concerns the future. To quench its anxiety, our brain always seeks clarity and definiteness in all matters, even in matters where there is none. If the brain can’t find it, it makes one out of its imagination. I could be wrong about the market, as I have been for the past year. However, from a risk perspective, it is worth considering how your portfolio, financial situation, or lifestyle will be impacted if a crisis ensues in less than one year and stock prices decline by 30 – 50 per cent.
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