The lessons learned from the 1987 stock market crash are traders who believe the Fed will cut interest rates

No recession, no problem? Investors appear to be confident that the Federal Reserve will embark on a historically aggressive round of interest rate cuts this year, even as the economy avoids a hard landing.

Fed policymakers have seen this movie before and didn't care about the ending, Nicholas Colas, co-founder of DataTrek Research, said in a note Tuesday. Investors may want to review the action and adjust their expectations.

Fed fund futures traders are pricing in five to six quarter-point rate cuts by the end of the year, in contrast to the Fed's summary of economic forecasts, also known as the “dot plot,” which calls for just three quarter-point rate cuts in 2024 .

Economists have linked the aggressive rate cuts to expectations that the Fed will try to keep real, or inflation-adjusted, interest rates stable as inflation continues to fall. The Fed is widely expected to keep interest rates at 5.25% to 5.50% when it concludes its two-day policy meeting on Wednesday, with the market more than likely to cut it by the next meeting in March Priced at 50%.

Related: Why analysts say the Fed risks clogging financial pipes if its policies don't change

Meanwhile, stocks have returned to all-time highs, with the S&P 500 SPX and the Dow Jones Industrial Average DJIA each posting their sixth record close of 2024 on Monday.

DataTrek took a look back at past easing cycles to see how market expectations for a decline of at least 1.25 percentage points in the coming year matched previous easing cycles. As shown in the chart below, they found only one instance in the last 44 years in which the Fed cut interest rates by 1.25 percentage points or more in a year without a recession underway or clearly on the horizon.

DataTrek Research

It happened in 1985-86. The Fed had raised the key interest rate to 11.6% in August 1984 before launching a mid-cycle easing program that raised it to 5.9% by October 1986.

These cuts fueled the stock market rally: The S&P 500 rose 31% in 1985, 18% in 1986, and another 31% by the end of September 1987, Colas noted.

Students of market history know what happened next. On Black Monday – October 19, 1987 – the S&P 500 plunged more than 20% in a single day, while the Dow fell 23%. The S&P 500 ended the fourth quarter of 1987 with a loss of 23%.

“The Fed knows the cautionary tale of 1985-1986, and with absolute interest rates now lower, it has even more reason to be cautious about the pace of rate cuts in 2024,” Colas wrote. “Without an impending recession, there is simply no precedent for +1.0 point rate cuts this year.”

Furthermore, “stocks are already doing so well that the risk of an unsustainable rally (à la 1987) is very high indeed,” he wrote.

Colas acknowledged the possibility that fed funds futures are “trying to tell us something about the potential for a recession.”

In fact, the apparent contradiction between Fed funds and other markets has attracted a lot of attention. Deutsche Bank strategists noted earlier this month that the extent of the market's discounted cuts was almost always accompanied by a recession, while the episode in the mid-1980s came after interest rates had been raised to a highly restrictive range, when the Fed led by Paul Volcker put pressure on monetary policy to bring inflation into submission.

In a diagram: Why stock market bulls should be careful what they want from Fed rate cuts

However, Colas doubts that the short-term interest rate market is sending an economic warning signal.

Fed fund futures traders “are probably betting that the Fed will want to become less restrictive as inflation continues to fall,” Colas said. “According to the math, that’s completely fine. However, it does not fit the historical data or the Fed’s institutional memory.”