Fed Rate Cuts: A Common Precursor to Market Tops

Last week's big news was that Federal Reserve Chairman Jerome Powell said in a speech in Jackson Hole, “The time has come for policy to adjust.” He went even further than I thought he might, suggesting that there could be "ample room to cut rates," sparking huge changes in the bond market and investors' expectations for future rate cuts. If you’ve been paying attention over the last couple of years, you would recognize that this aligns with Powell’s history of “signaling” his intentions to the markets well before taking action.

Options traders like you and me don’t have to know all the intricate details of every word the Fed says or how policy changes impact different bond markets. However, we should have a broad understanding of the implications of these rate cuts on the markets and economy, given that over the past 25 years, the Fed’s power over the market has grown considerably. So, I got up early this weekend with a large pot of coffee and started looking at data from the past three major rate-cutting cycles.

Analyzing the data over the last two decades, I found that when the Fed began a rate-cutting cycle, it was typically followed closely by market tops and increased volatility. The good news for you is that, as options traders, we love periods like this because it means option premiums will be higher and we’ll finally have market conditions conducive to unleashing different strategies that might not have worked in this long period of low volatility. Remember, volatility is an opportunity, and we seem to be on the cusp of a big opportunity.

Before I discuss the adjustments I’ll be making to my trading, let’s look at the three different rate-cutting cycles:

December 2000 Cycle (Tech Bubble)

Starting back in time and moving forward, I first looked at the Tech Bubble or Dot.com Bubble rate cut cycle beginning in December 2000, which saw the S&P 500 (SPX) starting around 1,369 when the Fed initiated the first significant rate cut. If we then look at the SPX price one year later, we find that it had dropped to 1,158, a decline of about 15%. By June 2002, 1.5 years after the first cut, the SPX had dropped to 1,027, resulting in a total decline of nearly 25%. At its lowest point in September 2001, the SPX had fallen to 944 - a drawdown of more than 31%.

What’s initially surprising, and you’ll see was a continuing theme for other rate-cutting cycles, was that the Fed’s first rate cuts never seemed to attempt to rescue the market from a previous decline. Instead, it’s evident that the Fed’s rate cuts were almost like they were predicting hard times ahead and were trying to get “ahead of the curve,” so to speak.

Next, I looked at the unemployment rate to see if there were any additional indicators that rate-cutting cycles were actually more predictive of market tops and economic slowdowns, and sure enough, the unemployment rate increased by approximately 2% over the same period.

This cycle, which unfolded during the bursting of the dot-com bubble, shows how rate cuts can coincide with worsening market conditions and rising unemployment. Probably not the image that comes to mind when most people think about rate cuts.

August 2007 Cycle (Global Financial Crisis)

The next major cycle began in August 2007 when the Fed started cutting rates in the beginning stages of what is now referred to as the Global Financial Crisis and/or the Great Recession. At that time the SPX was trading at approximately 1,433 and within a year, the index had dropped to 1,260, a 12% decline. As we all know now, the markets continued their downward trend, and 1.5 years later the SPX closed at 823 in February 2009 - a staggering 42% drop from the start of the cycle. This was actually a bit better than the lowest point during this cycle which came in March 2009, when the SPX reached 666, a decline of 53%.

Like in the previous cycle, the unemployment rate rose sharply during this period, increasing by over 4% over the next 1.5 years. This period, marked by the global financial crisis, is yet another reminder that there’s a potential for a big uptick in volatility and a significant market downturn with rising unemployment anytime the Fed starts a new rate-cutting cycle.

August 2019 Cycle (COVID Pandemic)

The last major rate-cutting cycle during the COVID Pandemic started in August 2019 with the SPX trading around 2,898. This cycle was slightly different, though history might prove otherwise, in that we had a global pandemic shock that saw extreme volatility in both directions (up and down) with even more extreme government intervention and policy. But all that aside, purely looking at the SPX price action, by March 2020, the SPX had dropped to 2,191 - a nearly 25% decline and one of the fastest market drawdowns ever on record. However, despite this steep decline, the market began to recover at equally the fastest pace on record, reaching 3,288 a year after the first rate cut and 3,731 by 1.5 years later.

The unemployment rate also saw a dramatic rise, increasing to nearly 15% in the immediate aftermath of the pandemic but then equally as quickly coming back down before settling around 5-6%.

While the 1 year and 1.5 year analysis periods showed this cycle “outperforming” the two previous cycles, it’s not like the market didn’t have a drawdown following the first rate cuts or that traders didn’t experience extreme volatility; both happened. What’s more interesting, to me at least, is the policy reaction which might set the stage for another similar policy reaction if (when) we see another recession.

Buy the Rumor, Sell the News?

I think this research might be very confusing to some investors. On the face, we’re told that low interest rates are good for the market, meant to spur economic growth and fuel the markets. However, as the charts above illustrate, over the last three examples in the 21st century, the market has gone down (not up) when interest rates are cut. In fact, what’s super fascinating to me, is that our research on market performance during increasing rates, showed the exact opposite.

All of this seems counterintuitive. But perhaps this is an example of the famous trading adage, “Buy the rumor, Sell the news.” Investors anticipating a rate cut front-run the market and buy before the cut is announced. Once the Fed actually cuts rates, markets turn over.

Likewise, once rate cutting begins, unemployment rates tend to go higher over the next 1 and 1.5 years.

Of course, the natural argument against this is that rate-cutting happens in response to rising unemployment and the potential of a recession. After all, that’s why the Fed first raises rates, right? To intentionally slow down a supposedly “hot” economy.

What This Means for Traders Today

Simply put, it means we are likely to see a return of volatility and a break from the “slowly grinding higher” environment that we’ve seen in recent years. Again, as options traders, this is a great opportunity, and here’s how I’m personally adjusting my portfolio:

Tilting bot exposure slightly more bearish. It's not like I was ever personally ultra-bullish with my trades, but if my bots have to pick a side, I’ll give them the flexibility to lean more bearish in longer-dated positions. So, I’m adjusting my bot beta exposure to allow for more of a bearish tilt to all positions.

Plus, if you're just looking to place a few bearish trades, you can use Trade Ideas to filter for the best opportunities. Here's what my preset filters look like for a bearish trade:

Continued focus on 0DTE. One of the beautiful things about my newfound excitement for 0DTE trading is that I don’t always have to commit capital for 45+ days to see a trade play out. Instead, my 0DTE bot can selectively trade each market day as its own event with 0DTE contracts. And if we are bound to see higher volatility, that gives me a chance to reassess each day for the latest 0DTE opportunities vs. parking capital in a 45+ day trade that gives markets more time to move against me.

Since 0DTE contracts behave differently than normal contracts, particularly when it comes to 0DTE time decay, we built the 0DTE Oracle to help you analyze 0DTE trades better.

Adding to my VIX Hedge. My VIX hedging strategy worked well this month, as I took profits on a few tranches of the VIX hedge earlier when the market had its quick drop on that sent the VIX above 50. Today, with the VIX back in the 15 range, I need to make sure not to miss an opportunity to re-establish more tranches of long volatility exposure.

It remains to be seen whether this rate-cutting cycle will follow the same path as its predecessors. But I think about this research like preparing for a long drive. I don’t just hop in the car and hit the road blindly without a map or directions or checking the weather. Similarly, our best strategy, knowing that we 100% know we are in a new rate-cutting cycle, is to be proactive and make adjustments now before things happen.

If you take small actions now, it will pay big dividends later. I shared my opinion on this and the actions I’m taking and I’d love to hear your thoughts as well in the Community.