UBS Warns: Aggressive Fed Cuts Could Lead to a New Stock Market Bubble

UBS analysts have indicated in a recent report that aggressive interest rate cuts by the Federal Reserve might pave the way for a new bubble in the stock market.

Historically, markets have tended to respond favorably in the short term following the first rate cut, experiencing an average increase of 4% over the subsequent eight months. UBS noted that if a recession occurs, markets typically decline by 10%, whereas in the absence of a recession, they tend to rise by 20%. Recessions have historically occurred around five months after the onset of rate cuts, with a 55% chance of a recession happening during that timeframe.

The firm expresses concern that a more assertive Federal Reserve could drive interest rates down further than anticipated, potentially leading to a market bubble. The prevailing expectation is for a trough in the Fed Funds rate around 2.8%. However, UBS points out that interest rates have often dipped below neutral levels during economic downturns.

UBS also argues that economic conditions may now be less sensitive to changes in interest rates compared to previous cycles, which could result in lower rates and a weakened U.S. dollar. They forecast the dollar to reach approximately 1.15 and 130 by the end of 2025.

When it comes to equities, the analysts adopt a cautious stance, highlighting that significant gains have already been realized in the stock markets leading up to the anticipated rate cuts. They see limited potential for further upside unless negative economic developments occur. UBS mentions that equities appear only marginally undervalued if one assumes that advancements in generative AI will boost productivity growth by 1% starting in 2028.

Despite the cautious outlook, there is a risk that aggressive rate cuts could foster conditions conducive to a market bubble. UBS notes that a steepening yield curve, particularly in the shorter term, would benefit consumer sectors (excluding luxury) and defensive investments. They recommend maintaining a focus on these sectors, asserting that small-cap stocks, which have three times more floating-rate debt than large-cap stocks, are likely to outperform, along with quality stocks, and to a lesser extent, growth stocks.