Fed rate cut boosts stock markets - might the need for hedging options increase in the event of possible market corrections?
The US Federal Reserve (Fed) has initiated a turnaround with a significant rate cut. The federal funds rate was lowered by 0.50 percentage points to a range of 4.75 to 5 percent, surprising many market participants. The leading indices in Germany and the US initially reacted positively, reaching new highs. However, fears of recession or inflation could lead to a correction in the equity markets, which in turn would likely increase the need for hedging from an investor perspective.
US monetary policy leads the way
Market participants eagerly awaited the Federal Reserve's decision on interest rates. Although a rate cut was expected in advance, the actual level was unclear until the very end. The committee, led by Federal Reserve Chairman Jerome Powell, ultimately decided to make a significant move, initiating the largest rate cut cycle since the coronavirus pandemic.
At the press conference, Jerome Powell emphasized that the US labor market and the development of the US economy as well as the right timing played a role. Although the US economy remains strong, there are signs of a weakening trend in the labor market. According to the Fed's projections, the US unemployment rate should not exceed 4.4% on average by the end of the year. For this reason, the Fed wants to take countermeasures in a timely manner, taking full employment into account in addition to its mandate of price stability.
The markets expect two more (small) rate cuts by the end of the year. However, experts are currently debating what level the key rate will reach by the end of 2024 or in the course of 2025. The key question will be to what extent the Fed can lower the federal funds rate without reigniting inflation. In general, markets are expecting increased turbulence around the upcoming US elections in early November 2024.
Markets rise after rate decision
Following the rate decision, leading indices around the world initially rose. The DAX® in Germany topped 19,000 points for the first time, while the S&P 500® in the United States passed 5,700 points. Both indices reached new all-time highs. But is the euphoria in the markets really justified, or is there cause for concern?
The head of the BlackRock Investment Institute cautions against excessive euphoria, even if markets initially react positively to the rate cut. A look at past Fed easing cycles shows that equity markets often rallied at the beginning. As bonds became less attractive due to falling interest rates, capital increasingly flowed into the stock market. However, the sustainability of this effect ultimately depends on how the economy evolves (risk of recession) and how inflation develops.
Goldman Sachs experts have analyzed the performance of the S&P 500® after the first rate cut in the last five rate cut cycles since 1984 in which the economy did not quickly fall into recession. Historically, the S&P 500® has gained an average of six percent in the first three months, nine percent in the first six months, and 17 percent in the first 12 months. However, if a recession occurs within 12 months of a rate cut, double-digit losses are quite possible. It remains to be seen whether history will repeat itself. Empirical evidence shows that past prices have limited predictive power. An additional factor this year is that the U.S. presidential election will take place later in the year, which could lead to a year-end rally.
A key question for investors in such a market environment is whether or not the U.S. economy will slip into a recession. Depending on the answer to this question, it may be more appropriate to overweight the equity market or to take a more defensive position. If investors want to protect gains from an excessive correction, hedging may be an option.
Wide range of structured products for hedging purposes
Vontobel offers a wide range of investment and leverage products that investors can use to hedge against falling prices, at least to some extent. In the investment area, reverse convertibles with a low strike price or capital protection products could be of interest. On the leverage side, there is a wide range of put warrants and short mini futures on various underlyings that investors can use to hedge their portfolio positions as they see fit. Overall, this allows investors to develop a strategy for their portfolio even in the event of falling prices.
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