Interest Rate Cuts: A Blessing or a Curse for Your Stocks?

Key Takeaways

• Since the 1970s, the performance of the S&P 500 has been slightly below average in the 12 months after the first rate cut of a monetary-policy easing cycle.
• When looking only at rate cuts that have coincided with soft landings, as opposed to recessions, the S&P 500’s return has been far above average.
• The Federal Reserve last Wednesday reduced the benchmark interest rate by half a percentage point, a jumbo cut that boosted sentiment on Wall Street Thursday, powering stocks to record highs.

The Federal Reserve last week cut its benchmark interest rate for the first time in more than four years, beginning a long-awaited process of normalizing monetary policy after holding rates at a two-decade high for more than a year. 

Market participants, who were abnormally uncertain about the outcome going into the latest Fed meeting, weren’t immediately sure what to make of the decision. Eventually, jitters about the magnitude of the Fed’s half-percentage point cut wore off and stocks surged to record highs on Thursday. 

Wall Street’s reaction reflected a peculiar mix of apprehension and optimism in financial markets. On the one hand, rate cuts are broadly supportive of the stock market because they reduce the returns of fixed-income investments and promote business growth. But easing monetary policy is also often a sign that policymakers see trouble ahead for the economy, and that is especially true of large cuts like last week’s.

How Do Stocks Usually Perform After Rate Cuts?

Wall Street’s enthusiasm on Thursday was, from a historical perspective, more warranted than its caution on Wednesday.

According to a recent Bank of America (BofA) analysis, of the last 10 Fed policy-easing cycles—going back to 1974—the S&P 500 has returned 11% on average in the 12 months following the first rate cut. That’s slightly below the index’s average return of 12% a year since the start of the 1970s, but a respectable return nonetheless. 

However, half of those 10 rate cuts were followed within 12 months by a recession. When you remove those cuts that coincided with recession, the S&P 500’s average 12-month return jumps to almost 21%.

Has the Rate-Cut Rally Already Happened?

Some have expressed concern that the stock market’s strong showing so far this year could limit the S&P 500’s near-term upside. After all, Wall Street has been anticipating that the Fed would cut rates all year, driving the S&P 500 up about 20% since the start of the year.

BofA analysts, however, found little in the way of a clear relationship between performance heading into and out of a first rate cut, challenging the supposition that the boost stocks get from cuts is front-loaded. For example, in 1995, the S&P 500 was up 26% over the prior 12 months and was within 1% of its then-all-time high when the Fed started to cut rates. The index went on to return 23% over the next year. 

The lead-up to 1995’s rate cut is arguably more similar to today’s than any other recent easing cycle. Before Wednesday’s rate cut, the S&P 500 was up 27% in the prior 12 months and was also within 1% of its all-time high. Additionally, 1995’s easing cycle was characterized by both a soft landing—an outcome many economists are increasingly confident today’s Fed can achieve—and massive spending on the infrastructure of the internet, paralleling today’s artificial intelligence (AI) spending. 

Read the original article on Investopedia.