Why stock prices don't always rise when the US Fed cuts interest rates

Investors worldwide are positioning themselves for a stock-market surge, encouraged by signals from the US Federal Reserve (Fed) that it will soon begin cutting interest rates. After all, the conventional belief is that stocks rise when the Fed cuts rates. Expectations of a 0.5 per cent cut at this month’s Fed meeting are growing, since inflation has cooled significantly, and is now nearing the Fed’s target of 2 per cent. Will rate cuts truly lead to higher stock prices? Disappointingly enough, the historical data shows that interest-rate changes — whether increases or cuts — are not strongly correlated with stock-market performance, as measured against broad market indices like the S&P 500. Let’s begin with a recent example: Rate increases.

In mid-February 2022, I had speculated in these columns whether markets would actually rally if the Fed raised rates to combat inflation. This hypothesis contradicted the orthodox belief that markets fall during rate increases and rise during rate cuts. My view was derived from the publicly available data. For instance, between mid-2004 and mid-2006, the Fed raised rates 17 times, yet the S&P 500 gained 46 per cent. Similarly, from December 2015 to December 2020, the Fed raised rates nine times, from 0.25 per cent to 2.5 per cent, and the S&P surged from 1,900 to 2,800. Interestingly, the index wobbled in 2018 toward the end of the three-year rate-increase cycle, not at its outset.

So, what happened in 2022? Amid continued rate increases by the Fed and the ongoing Ukraine conflict, markets did indeed dip for a few months. Yet, defying conventional wisdom, markets rebounded even before the Fed had completed one-third of its intended rate increases. The S&P 500 hit a low of around 3,500 in October 2022, and then climbed to 4,600 by July 2023; as rates went higher, so did the index. During this period, the Fed raised rates six times, from 3.25 per cent in November 2022 to 5.5 per cent by July 2023. Intriguingly, after the Fed paused its increases in July, the S&P 500 declined until October. From October onward, however, the index surged relentlessly to 5,650 until a sharp correction last week, all while the economy contended with a high 5.5 per cent rate. In a full cycle, the rates rose from 0.25 per cent to 5.5 per cent and were held there for a year. Yet the markets continued to march higher — seemingly to a tune different from the Fed’s.

This isn’t the first time a presumed correlation between the Fed’s rate changes and stock market movements proved unreliable. What about the opposite scenario — do markets rally when the Fed cuts rates? Here too, the relationship is weak. The most striking example comes from 2008. In January 2008, the Fed cut rates from 3.5 per cent to 3 per cent following a market crash. By March, Bear Stearns collapsed, prompting another 0.75 per cent rate cut to 2.25 per cent. In April, rates were further reduced to 2 per cent, yet the market spiralled downward between June and September, when Lehman Brothers collapsed in September.

By October, rates were slashed to 1.5 per cent, then to 1 per cent, and by December, down to 0-0.25 per cent. Despite these drastic cuts, the 2008 crash ranks among the most severe in modern history, with the S&P 500 plummeting 50 per cent from January to March, precisely when the rate fell from 3.5 per cent to zero. Far from boosting the market, the cuts could not even prevent a crash. The same pattern had occurred in 2001: The Fed cut rates from 5 per cent to 1.25 per cent by November 2002, yet the S&P 500 dropped from 1,530 in August 2000 to 794 in September 2002, only recovering after March 2003.

Why, then, do many persist in believing that interest-rate movements are strongly correlated with market performance? Perhaps it’s intuitive: If money — the lifeblood of the market — becomes more expensive, it seems logical that markets would falter. Yet, other factors are at play, explaining why stocks can rise even as rates increase. Typically, the Fed raises rates in response to robust economic growth (which may manifest as higher inflation). In a strong economy, corporate profits grow, leading to rising stock prices. Stocks are less concerned with conventional wisdom than with corporate fundamentals and valuation. As the economy expands, the Fed increases rates incrementally. If growth remains solid, corporate profits rise, lifting stock prices. A strong economic growth rate can prompt further rate increases. This cycle of rising rates and rising stock prices illustrates that the Fed often follows the economic cycle — it doesn’t lead it.

Could the unthinkable happen now, that is, could markets fall when rates are cut? It’s possible, under the right conditions, which is slower growth. When the Fed stops raising rates, it can signal that economic growth is already slowing (the Fed lags, not leads), which could hurt corporate profits, and, consequently, stock prices. Sometimes, even rate cuts can’t reverse a downturn if prior hikes were too aggressive. When growth slows — whether due to rate hikes or other factors — markets react negatively. Of the many forces shaping stock prices, economic growth, corporate profits, and valuation are paramount. These deserve more attention than interest-rate movements alone.

The writer is editor of www.moneylife.in and a  trustee of the Moneylife Foundation; @Moneylifers