Explained: How Rate Cuts Could Kill The Bull Market

The stock market has been on a tear this year, with the S&P 500 Index up almost 15% despite dwindling rate-cut expectations and continued geopolitical tensions. After keeping policy rates steady last week, Fed Chair Jerome Powell acknowledged the progress the U.S. economy has made in recent months toward achieving long-run inflation of around 2%. Revealing rate cut expectations of policymakers, Mr. Powell noted that the Committee does not have the confidence to lower rates just yet despite certain macroeconomic indicators such as core inflation and job openings pointing to cooler inflation. FOMC members lowered their expectations for rate cuts this year from three to just one, citing that modest progress toward 2% inflation is not sufficient to adopt a more expansionary stance on monetary policy.

What Is The Relationship Between Interest Rates and The Stock Market?

Economic theory suggests that there is an inverse relationship between interest rates and stock prices, meaning stock prices increase when interest rates decline and vice versa. That said, investors need to understand that these two variables do not have a perfect correlation, which could result in market movements that cannot be explained by the perceived inverse relationship between stocks and rates.

In a low-interest-rate environment, analysts will use relatively low discount rates to calculate the present value of expected cash flows from companies in their coverage, which results in a higher present value compared to when rates are higher. For this reason, growth companies tend to attract premium valuation multiples when interest rates are low. The opposite is true when rates are high.

As investors, it is important to assess many other macroeconomic variables such as corporate earnings growth, geopolitical developments, fiscal support, and tax rates to gauge a measure of expected stock market returns.

Making The Case

Investors have been cheering for a rate cut recently but empirical evidence suggests the stock market performance following a rate cut may not be as rosy as investors expect it to be. Since 1974, following the first Fed rate cut in a new cycle, the S&P 500 has declined approximately 20% over 250 days. There have been 10 new expansionary cycles since 1974, and the S&P 500 has declined after each of the first rate cuts in these cycles. This evidence strongly suggests that the market is likely to experience a major drawback in the months following the first rate cut in the upcoming cycle, which could begin as early as September. That said, in the long term, low interest rates are likely to support higher stock prices similar to how they have in the past.