The Federal Reserve (Fed) has just delivered its first rate cut, marking the end of the “higher for longer” period and ushering in a new cycle of rate reductions that are likely to continue well into 2025. While this might sound like good news for stocks, it’s not necessarily a guaranteed win.
Rate cut cycles aren’t exactly commonplace. On average, we see one about every ten years, reflecting the Fed’s strategy of aligning rate adjustments with the economic cycle. When the economy is thriving, the Fed raises rates to keep growth in check. Conversely, during economic slowdowns, they lower rates to stimulate spending and boost economic growth.
Looking at the S&P 500 index alongside the Effective Fed Funds Rate (the chart above highlights the first rate cut in each cycle), we can see that while rate cuts have historically been associated with positive stock market performance, the relationship isn’t always immediate or straightforward. Experienced investors remember years like 2001 and 2007 when the stock market continued to decline for months following the first rate cut. Although the S&P did experience a surge for about six to seven months after the initial rate cut in 2019, the COVID-19 pandemic fundamentally changed the market landscape, making it difficult to determine how the market would have performed without that disruptive event.
To get a fuller picture of the interplay between interest rates and stock market behavior, let’s examine the yield curve. The chart below displays the spread between the Ten Year Treasury Yield and the Two Year Treasury Yield, commonly known as “2s vs 10s” in financial circles. When the spread between these yields dips below zero, we have what’s known as an inverted yield curve, which is often a harbinger of an impending recession.
Notice how nearly every recession has followed a similar pattern. First, the yield curve inverts, signaling waning confidence among fixed income investors in future economic growth. Eventually, the yield curve normalizes, and shortly thereafter, the stock market begins to decline as the economy enters a recession.
Does this mean we’re guaranteed to see lower stock prices this time? Not necessarily. It’s crucial to remember that interest rates and the Fed are just two pieces of a vast, dynamic, and complex system of economic indicators. While history offers valuable lessons, it doesn’t predict the future.
The key takeaway here is that while rate cut cycles have often been favorable for stocks, the benefits aren’t always immediate. Investors should remain vigilant, keep an eye out for potential downtrends, and focus on areas of the market showing relative strength amidst the uncertainty. As always, stay informed, stay alert, and make investment decisions that align with your individual risk tolerance and financial goals.
