The idea that interest rate cuts automatically propel the stock market higher is a persistent myth. While interest rate reductions can impact cash flow into money markets, they don’t necessarily translate into stock market gains. This is because every stock purchase has a corresponding seller, meaning no new money actually enters the market. The process is simply a transfer of funds between buyers and sellers. Even in initial public offerings (IPOs), primary investors and the company sell shares to new buyers, effectively shifting funds from one party to another.
Despite this, the myth of sidelined cash persists, especially during bullish periods. However, historical data suggests that falling money market yields haven’t led to a significant exodus of money from these funds. For example, in 2005-2009, when money market yields declined, assets in these funds actually surged.
This is partly because much of the money in money market funds serves other purposes like emergency savings, corporate reserves, or short-term expenses. Investors often prefer to keep their money in these safe and liquid assets, even when interest rates drop, as they are less likely to chase stock market volatility.
The relationship between interest rates and market behavior is intricate. During periods of falling yields, investors might shift to other safe havens like bonds rather than chasing stock market gains. This often signifies a flight to safety, and equities are considered too risky for such scenarios.
Furthermore, the bond market experienced a tumultuous period in 2021 and 2022, making it one of the worst times for fixed-income investors. Rising interest rates pushed the 10-year yield to nearly 5%, a level not seen since July 2007.
Considering the current economic landscape, characterized by historically high price-to-earnings (P/E) ratios, a prolonged market consolidation seems plausible even with a soft landing. This could allow earnings growth to become a more significant driver of market re-pricing, reducing inflated P/E ratios without requiring new cash inflows.
Ultimately, it’s not cash flow but the willingness of investors to pay that determines stock prices.
