Is the Stock Market Facing Red Flags Despite Interest Rate Cuts?

Stock Market Collapsed During IT Bubble Despite Soft Landing
Rate Cuts Favor Only the Bond Market When Economy Is Weak
"Volatility Rising... Time to Consider Increasing Dividend Stocks"

The timing of a U.S. interest rate cut is drawing closer. There is a common belief that when interest rates fall, the stock market rises due to increased preference for risk assets. On September 1, DB Financial Investment released a report titled "Stock Market Warning Light Triggered by Interest Rate Cut News," advising, "The timing of the U.S. Federal Reserve's interest rate cut could shake the stock market, so risk management is essential."

Stock Prices Can Fall Even with a Soft Landing

There is a view that the stock market declines during a hard landing, while a soft landing puts less pressure on stocks. By definition, a soft landing means that the gross domestic product (GDP) growth rate remains positive but is declining. In other words, the economy continues to grow, but at a slower pace. It is clear that during a hard landing, such as the 2008 global financial crisis, the stock market declines.

However, during the collapse of the IT bubble in the late 1990s, the stock market plummeted even amid a soft landing. During the IT bubble collapse, the U.S. real GDP growth rate never turned negative year-on-year. Nevertheless, the historic event of the IT bubble collapse occurred. If, as during the IT bubble collapse, stock market valuations are high, the stock market can experience significant volatility even in a soft landing scenario.

'Interest Rate Cut = Stock Price Increase' Is a Misconception

There is a common belief in the stock market that stock prices rise when interest rates are cut. However, this only holds true when the rate cut is preemptive, ahead of economic deterioration. If the rate cut is made in advance, all other things being equal, only the discount rate-which is the denominator in valuation-falls. When the denominator decreases, the overall valuation figure inevitably increases.

However, if an interest rate cut follows after the economy has already weakened, stock prices decline. The perception spreads among investors that a rate cut cannot immediately reverse the economic downturn, prompting stock prices to fall in line with fundamentals. Kang Hyunki, a strategist at DB Financial Investment, analyzed, "Historically, most well-known periods of stock market decline have coincided with interest rate cuts. Both the IT bubble collapse and the financial crisis occurred during periods of rate cuts."

This can also be explained by the supply and demand dynamics of financial markets. After economic weakness, a rate cut triggers a rally in the bond market. As funds flow into the bond market, the stock market weakens. This is why the stock market tends to drop sharply when long-term U.S. Treasury yields fall steeply.

Stock Market Volatility May Expand Now

If stock market valuations are high, the economy is experiencing a soft landing, and interest rate cuts are implemented after the fact, the stock market can decline. Currently, these conditions are particularly present in the U.S. market.

U.S. stock market valuations are at their highest since the IT bubble collapse. The U.S. economy could decline due to a weakening labor market and tariff burdens. In addition, a Federal Reserve rate cut is expected in the second half of the year. Every time there has been a discussion of a rate cut due to concerns about the U.S. economy from last year to recently, stock market volatility has increased following a decline in long-term U.S. Treasury yields.

Therefore, as the Federal Reserve proceeds with rate cuts and long-term U.S. Treasury yields fall sharply, it is important to consider the possibility of increased stock market volatility. Strategist Kang Hyunki analyzed, "From the perspective of improving relative returns, the right response is to increase the proportion of dividend stocks. Since U.S. and Korean interest rates move along similar paths, and dividend stocks have shown relative strength in the Korean stock market during Korean rate cuts, it is reasonable to increase the relative proportion of sectors with high dividend yields and low beta (volatility)."