How do stocks perform when the FED cut rates?
Many traders are wondering how stocks will perform after FED cut rates on July’s meeting, as many doubt on the timing of the decision. FED cutting rates with the stock market at all-time highs? Yes, the market has seen that in the past.
Before evaluating the possible effect of a 25 points or 50 points rate cut, some key economic principles must be put into perspective. What explains the stock market's reaction to a cut? How do interest rates affect the stock market? To understand the effects of a rate cut, traders must have clear how money circulates in the US economy.
When the Federal Reserve decides to cut interest rates, also known as the discount rate or short term federal funds rate, what the FED is doing is simply boosting the economic throughout certain transmission mechanisms. Once they decrease the cost of borrowing money, they are affecting the money supply in the system. By cutting rates, the money supply will rise, as money will be easier to obtain.
People will find loans more attractive, in other words, it is cheaper to borrow. The increase in the money available in Americans’ pockets will boost consumption, and consequently, impact companies revenues positively. The other side of the coin, the industrial and commercial sector, will be experiencing very similar outcomes. Businesses will also borrow funds from financial institutions in order to expand their operations and meet the surging demand.
Now, once those concepts are clear, you are able to understand the outlook described in the following paragraphs.
Markets have not experienced a rate cut since September 2007 and with the S&P already 15% up this year, projections are now in the spotlight. There are many debates on where the impact will be positive or negative. Many bearish stock traders are betting on a huge market correction similar to 2008, while many others are already going long on American indexes.
The truth is, both are not wrong, to a certain extent. A deep analysis of the FED rate cut cycle shows that market dynamics changes between 6 and 12 months after the first and second rate cut. Saying that the 2008 US recession came directly after the cut is a huge mistake.
For the purpose of this article, I will only be highlighting the effects of the last three rate cuts in US history (1998, 2001 and 2007). In 1998, the S&P 500 earned 8.84% in the first month after the cut and 20.87% after the first 3 months. On our second case study, the FED rate cut cycle starting in 2007, the stock market rose significantly during the first month but declined 8.53% after three months and -11.33% after 6 months. Finally, on the last rate cut, which started in 2007, S&P gained 1.48% after one month but started to drop after the first 3 months with losses over 3.83%. 12 months after the rate cut, S&P was down 13.36%, while 9 months after the market was bleeding harder due to losses over 20%.
If you haven't spotted the pattern yet, I will put it easier for you. If you go back in time, explosive rallies have come right after the first cut, however, after 6 and 12 months, momentum shifts and stocks can easily get cut by a half. One important point to take into account is that not all rate cuts are created equal. Investors must not create an outlook using previous cases, as economic conditions are not the same.