Recentinterest rate actions have exhibited behavior not observed since March 2020, potentially setting the stage for significant shifts in the stock market.
The U.S. Federal Reserve has two primary objectives: Maintaining an annualized increase in the Consumer Price Index (CPI) inflation rate at 2%, and ensuring full employment in the economy, although there's no specific target for unemployment rate.
The Federal Reserve adjusts the federal funds rate (overnight interest rate) to help achieve these objectives. For instance, it embarked on one of its most aggressive interest rate hikes in 2022, when the CPI reached a 40-year high of 8%. Thankfully, inflation has significantly decreased since then, allowing the Fed to reduce interest rates for the first time since March 2020 in September, and again in November. More rate cuts might be on the horizon.
Conventional wisdom suggests lower interest rates are beneficial for the stock market, but history indicates a potential downturn in the S&P 500 in the near term.
Interest rates might reduce further in 2025 and 2026
The surge in CPI during 2022 was driven by various inflationary pressures, including:
- The U.S. government injecting trillions of dollars into the economy in 2020 and 2021 to counteract COVID-19 pandemic's negative effects.
- The Fed lowering the federal funds rate range to a record low of 0% to 0.25% in 2020 and pumping trillions of dollars into the financial system through quantitative easing (QE).
- Production facilities worldwide shut down due to COVID-19, leading to consumer goods shortages and soaring prices.
The Fed increased rates starting in March 2022, and by August 2023, the federal funds rate was at a 20-year high of 5.25% to 5.5%. This was necessary to cool down the economy after two years of stimulative policies.
Luckily, it worked. Inflation decreased to 4.1% in 2023, and it dropped to an annualized rate of 2.6% in October 2024 (the most recent reading). The Fed's 2% inflation target is now within reach.
This gave the Fed's Federal Open Market Committee (FOMC) confidence to decrease the federal funds rate by 50 basis points in September, followed by another 25 basis points in November. The FOMC's projections suggest another 25-basis-point cut might be imminent in December, along with 125 basis points' worth of cuts in 2025 and 25 basis points' worth of cuts in 2026.
The FOMC's forecast is dynamic, which means it could change over the next few months depending on new economic data. However, as of now, the federal funds rate might be under 3% in approximately two years.
The S&P 500 often declines after rate cuts
Lower interest rates can be advantageous for the stock market for various reasons, such as allowing corporations to borrow more money for growth and reducing their servicing costs, which directly increases their earnings. Furthermore, falling rates can reduce the yield on risk-free assets like cash and U.S. Treasury bonds, causing investors to buy stocks instead.
However, going back to the year 2000, every rate-cutting cycle by the Fed was followed by a brief correction in the stock market. The graph below, which overlays the federal funds rate (upper limit) with the S&P 500, illustrates this:
The S&P 500 consistently trends higher over time, so this apparent correlation is not a reason for investors to worry. Considering the Fed usually cuts rates because the economy is displaying weakness, the stock market declines are likely due to the economy's underlying problems rather than the interest rate cuts themselves.
The Fed decreased rates in the early 2000s because the dot-com tech bubble burst, which led to a recession. It then decreased rates in 2008 due to the global financial crisis, and in 2020, the pandemic was the catalyst for lower rates.
Surprisingly, the S&P 500 is trading near a record high right now despite the Fed's recent interest rate cuts, which is a positive sign, and there does not appear to be a looming economic crisis.
There are indications of economic weakness, and a recession wouldn't be unusual
The U.S. economy is performing well currently, but some weakness is emerging. For instance, the unemployment rate has slightly increased to 4.1% after starting the year at 3.7%. A worsening jobs market can lead to consumer spending weakness, which can impact economic growth.
Moreover, past experiences show that periods of rising interest rates often precede recessions. It makes logical sense because the Fed increases rates to slow down the economy, and economic weakness can quickly escalate into something more significant.
The graph below demonstrates the effective federal funds rate over the past six decades, marking recessionary periods in gray. Based on my personal observation, a recession typically struck the U.S. economy after the Fed raised rates:
Therefore, if there is a correction in the S&P 500, it's unlikely to be caused by interest rate cuts, but rather it might be due to the Fed's rate hikes' delayed effects on the economy.
Corporate profits serve as the foundation for fluctuating stock prices, making it challenging for corporations to expand during economic downturns. In the absence of earnings growth, the S&P 500 typically trades at lower levels. Moreover, the S&P 500 currently exhibits a remarkably high valuation, which might result in a more pronounced decline if a correction were to materialize.
Nonetheless, investors should not be hasty in their decisions to sell off stocks. Rather, they should psychologically prepare for a probable market contraction and devise a strategy to acquire stocks when the opportunity arises. It's essential to remember that historical data shows the S&P 500's propensity for ascending trajectories over the long term.
- Individuals who are keen on growing their wealth through investing might consider allocating part of their money towards stocks, as lower interest rates could potentially make borrowing more affordable for corporations, leading to increased earnings and perhaps higher stock prices.
- As the Federal Reserve continues to monitor economic indicators and adjust its monetary policy, investors should remain vigilant, keeping in mind that past trends suggest a potential downturn in the stock market might follow interest rate cuts, despite the long-term upward trend of the S&P 500.
