Jerome Powell, the chair of the Federal Reserve.
Interest rate reductions are known to boost the stock market. Or perhaps not. The pioneer of contrarian analysis, Humphrey Neill, popularly remarked, “When everyone thinks alike, everyone is likely to be wrong.”
An excellent illustration is the response of the stock market to rate reductions by the Federal Reserve. Think of every time the Fed has lowered the target federal-funds rate since 1980. The stock market was lower one month later in 40% of those situations, three months later in 37% of cases, and twelve months later in 27% of cases.
It is obvious that history does not support the notion that the stock market will rise if the Fed lowers interest rates at its September meeting, as is widely anticipated.
Why does the stock market occasionally drop after the Fed lowers interest rates? When the economy is reasonably healthy, a rate drop tends to cause the market to rise, and when it is poor, it tends to fall.
The stock market’s response to last week’s unexpectedly negative August jobs report, which increased the likelihood that the Fed will lower rates at its meeting on September 16–17, can be better understood in light of this distinction. After learning of this surprise outcome, S&P 500 futures (ES00) SPX initially surged, but they quickly fell back, most likely as investors recognized that a recession would possibly be imminent. This possibility implies that if the Fed lowers rates this month, the market might do poorly.
Observing the Fed
A post-rate-cut market decline is supported by the relationship between the S&P 500’s daily movements and the likelihood that the Fed will lower interest rates this month. For the past 12 months, those rate-cut odds have been computed daily by the CME’s FedWatch program using 30-day fed-funds futures.
The majority of investors think that the correlation is inverse, meaning that a lower S&P 500 is linked to a higher projected fed-funds rate, and vice versa. However, I discovered the exact opposite: on days when the anticipated fed-funds rate from the September meeting was higher than a day earlier, the S&P 500 performed better on average over the previous 12 months. At the 95% confidence level, which statisticians frequently employ to assess whether a pattern is real, the association was significant.
Think about what occurred to the Fed-funds rate and the stock market following the “liberation day” tariff announcement in the Rose Garden of the White House on April 2. The likelihood of a recession, if not worse, was significantly raised by the tariffs.
Thus, it was not surprising that both the stock market and the anticipated fed-funds rate declined in the week following April 2. The typically sluggish fed-funds futures market saw a significant drop in one week when the S&P 500 sank more than 12% and the fed-funds rate forecast for the September meeting dropped 26 basis points.
A week later, President Donald Trump announced a 90-day halt on the majority of the “liberation day” duties, reversing both of these trends. On the day of the pause announcement, the S&P 500 surged 9.5%, and the implied fed-funds rate that emerged from the September meeting increased by 23 basis points.
Two significant investment implications are available to investors: The first is that investors ought to exercise caution when making wishes. A rate cut by the Fed might be negative.
The second is that investors should always be open to having their opinions examined statistically, particularly when those opinions are held by nearly everyone. They are the most hazardous because we blindly follow them because they are so commonly believed, which makes us particularly vulnerable if they turn out to be incorrect.
