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I am struggling to understand why equity markets seem to suffer shortly after fed rate cuts. Here is a rather telling chart:
Assuming not some kind of spurious relationship, what's the intuition behind the connection between rate cuts and equity dropping?
Maybe the rate cuts draws investors attention to the weakness of the macro conditions and makes them more risk-adverse?
If this trend holds for a longer series, my guess is that this is due to the correlation between the federal funds rate and general economic conditions. The federal funds rate is usually cut in anticipation of a weakening economy or during a period of low growth. It is well known that the expected returns on financial assets, including stocks and many other kinds of assets, vary with the business cycle. For example, see Fama and French (1989), "Business Conditions and Expected Returns on Stocks and Bonds." The most common explanation for this is that effective risk aversion is higher in bad times than in good times (e.g., as measured by GDP or aggregate consumption). This phenomenon is discussed more generally in the paper, "Discount Rates", by John Cochrane (2011). (Ungated access here.) For example, on p.1052, we read
There is a strong common element and a strong business cycle association to all these forecasts. Low prices and high expected returns hold in “bad times,” when consumption, output, and investment are low, unemployment is high, and businesses are failing, and vice versa.
