Rate-cutting playbook: What does history say about sector performance?

September rate cut is a done deal

Softer US labour conditions, further disinflation and a dovish lean from US policymakers have set the expectations for the US Federal Reserve (Fed) to kickstart its rate-cutting cycle in September this year, with the debate revolving around whether the Fed will deliver a 25 basis point (bp) cut or a larger 50 bp move.

Thus far, pockets of economic resilience suggests that US policymakers still have room to exercise some patience in its easing process, with markets rooting for a smaller 25 bp cut in September at a 69% odds. But further ahead, markets are suggesting that the September move will not be a “one and done”. A cumulative 100 bp worth of easing are priced by the end of this year.

As the Fed’s rate-cutting cycle looms, we look at some of the key sector performance in the lead-up to and after the first rate cut historically. However, we note that the data points can be limited and historical performance is no guarantee of future results, as economic conditions may differ.

Financial Select Sector SPDR Fund (XLF)

Rate cuts generally may have mixed implications for the financial sector. On one end, the lenders may face the risks of margin compression as lower interest rates may reduce the spread between the interest they earn on loans and the interest they pay to depositors. But lower rates may support more borrowing as well, with higher loan demand offering some cushion to margin pressures.

In the past six rate-cutting cycles (where data for XLF is available), the financial sector tends to see some slight weakness following the first Fed rate cut. Performance has been negative on all six occasions one month after the first rate cut, and negative on 5 out of 6 occasions three months after the cut. Performance has been more mixed in the lead-up to the rate cut and over the longer time horizon.

The Financial Select Sector SPDR Fund (XLF) has powered on to a new record high lately, after finding support off its daily Ichimoku Cloud and its 100-day moving average (MA) on several occasions. The broader upward trend remains intact, although price action may seem overextended in the near term with a break above a rising channel. Any retracement may leave the 44.12 level on watch as a support level to hold.

Consumer Discretionary Select Sector SPDR Fund (XLY)

Non-recessionary rate cuts are generally positive for the consumer discretionary sector, with cheaper borrowing costs potentially driving more take-up in automobile loans, mortgages and big-ticket spending.

In the past six rate-cutting cycles (where data for XLY is available), the performance for the consumer discretionary sector tends to be more subdued one month and three months after the first Fed rate cut. But thereafter, performance tends to improve further down the road, generally seeing a positive gain one year after the first cut.

Thus far, the Consumer Discretionary Select Sector SPDR Fund (XLY) has been trading on a broader wedge formation. The formation of higher highs and higher lows points to an upward bias, although it is still trading far below its November 2021 high. Any upside may have to face resistance at its July high around the 195.00 level, while on the downside, the lower wedge trendline at the 174.35 level may be on watch as immediate support to hold.

Technology Sector SPDR Fund (XLK)

Likewise, non-recessionary rate cuts are generally positive for the technology sector as well, with reduced interest rates translating to lower financing costs for the companies to pursue more innovation and expansion. With many tech firms valued based on their future growth, rate cuts could also mean lower discount rates being applied to their earnings and cashflow, which may make the companies being valued more attractively.

In the past six rate-cutting cycles (where data for XLK is available), the performance for the technology sector has generally been mixed in the lead-up to the first rate cut, with a huge disparity in terms of returns. But performance tends to improve one year later, except in severe recessionary scenarios such as in 2001 and 2007 where losses deepened further.

The Technology Sector SPDR Fund (XLK) has managed to pull off a higher low in early-August, keeping its broader upward trend intact, following a false breakdown of its 200-day MA. With some recent rotation from the outperforming technology sector to the laggard sectors, the index may have to push above its August high to reflect buyers taking greater control. On the downside, any further retracement may leave the 200.00 level on watch, with an upward trendline support in place.