Finance & Economics | Buttonwood
June 10, 2024
The long-awaited moment is approaching. For over two years, since the Federal Reserve embarked on its most aggressive series of interest rate hikes in decades, investors have been eagerly anticipating a pivot. Now, with market expectations solidifying, it seems inevitable that Jerome Powell, the Fed Chair, will announce the first rate cut after the Federal Open Market Committee meets on September 18th.
Market sentiment has shifted from “if” to “how much” rates will be cut. Current projections suggest a 40% chance of a 0.25 percentage point reduction and a 60% chance of a 0.5-point cut. It seems like a turning point—but history has shown that interest rate cuts don’t always bring the optimism investors crave.
Rate Cuts and Market Reactions
A Mixed History Interest rate cuts should, in theory, be good for stocks, as they lower borrowing costs for companies, allowing for better profitability, and make returns on equities more attractive compared to bonds. However, past cycles have proven that rate cuts are no guarantee of a bullish stock market. Consider the rate cuts under Alan Greenspan in the 1990s, which did boost markets. Contrast that with more recent history—cuts in the early 2000s were marred by the dot-com bubble, while 2007’s cuts coincided with the global financial crisis.
Even the Fed’s decision to cut rates in 2019 initially buoyed markets, only for the optimism to be wiped out by the onset of the COVID-19 pandemic.
The bottom line is that while lower rates reduce borrowing costs and increase consumer spending, they often come with other complicating factors. This time around, investors are asking: What factors might overshadow the potential benefits of a rate cut?
The Swamping Factors
Economic Weakness
Rates aren’t lowered in isolation. The primary reason for cuts is often concern about economic slowdown. Currently, though the U.S. economy has slowed, it hasn’t entered a full-blown recession. This means that company profits, and by extension stock prices, may hold steadier than they have in past cycles.
Lagging Impact of Tightening
As Milton Friedman famously said, monetary policy operates with “long and variable lags.” Even as the Fed looks to loosen, many firms face rising interest costs as they refinance fixed-rate debt that was issued during the near-zero rate environment. The same challenge awaits homeowners refinancing mortgages. This delayed impact on borrowing costs might dampen any immediate benefit from rate cuts.
Market Expectations
Perhaps the biggest challenge for investors is that the market has already priced in rate cuts. Traders are expecting up to 1.25 percentage points in cuts this year, followed by another 1.25 next year—levels typically seen only during recessions or crises. This high level of expectation sets the stage for disappointment if Powell’s cuts are more conservative than anticipated.
The Outlook for Investors
Investors might be tempted to celebrate as rates fall, but caution is warranted. If the market has already factored in the benefits, any further upside might be limited. Additionally, as debt servicing costs rise for firms and individuals, the broader economic impact of the cuts could be more muted than in previous cycles.
In the end, rate cuts should be good for the stock market. But when markets have already priced in their effects, the real benefit may have already been realized.
As always, investing successfully in these uncertain times requires a keen understanding of macroeconomic factors and careful attention to market signals. Whether this round of rate cuts delivers the optimism investors are hoping for, only time will tell.
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