When the Federal Reserve starts lowering interest rates, what does the stock market do? “It depends” is not a good answer.
“Investors have had no idea what would happen with the possible drop in the federal funds rate. Jason Goepfert, a senior research analyst at SentimenTrader, wrote in a note on Tuesday that there was no regular pattern in forward returns after big hiking cycles.
It is almost certain that the Federal Reserve will lower its key rate when its two-day policy meeting ends Wednesday afternoon. Also, traders think there is a greater-than-60% chance of an extra-large cut of 50 basis points, which is half a percentage point, instead of the normal move of 25 basis points. Stocks didn’t change much Wednesday afternoon, even though the S&P 500 SPX 1.54% briefly traded above its record close on July 16 and the Dow Jones Industrial Average DJIA 0.95% had a record close the day before.
Goepfert said that investors may remember that the last three initial cuts after a run of hikes were followed by terrible bear markets. But before that, he said, there wasn’t a clear pattern. He also said that returns didn’t change much depending on how far the S&P 500 was from a multiyear high at the time of the first cut.
When it comes to market performance and rate cuts, investors and experts have said that the bigger picture is important. If rate cuts are seen as stopping or slowing down an economic downturn, an easing cycle can be good for stocks and other risky investments.
Investors can be scared when they think that a central bank is cutting rates because it’s too late and has already let the economy slide toward or into the ditch.
Goepfert didn’t want to try to guess what the economy would do next. He wrote that the research firm was “not going to participate in the delusion that we can know whether this cut will precede an economic recession, which can dramatically impact forward returns.”
Based on past events, he said that the effects on stocks are not all good or all bad. Goepfert noticed that the maximum risk and reward across time frames had pretty clear-cut results (see table below). For the next year, stocks either saw “decent gains with low risk or limited gains with high risk,” with no in-between.
A decent rule of thumb was to watch the next two weeks after a cut, he said, noting that “if risk exceeded reward, then it was a strong suggestion that the following year would be tough.”
