Investors worldwide are positioning themselves for a stock market surge, encouraged by signals from the US Federal Reserve 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% cut at this month's Fed meeting are growing, since inflation has cooled significantly, and is now nearing the Fed's target of 2%. Will rate cuts truly lead to higher stock prices? Disappointingly enough, historical data shows that interest rate changes—whether hikes 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 hikes.
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 hikes and rise during rate cuts. My view was derived from publicly available data. For instance, between mid-2004 and mid-2006, the Fed raised rates 17 times, yet the S&P 500 gained 46%. Similarly, from December 2015 to December 2020, the Fed raised rates nine times, from 0.25% to 2.5%, 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 hike cycle, not at its outset.
So, what happened in 2022? Amid continued rate hikes by the Fed and the ongoing Ukraine conflict, the market did indeed, dip for a few months. Yet, defying conventional wisdom, the market rebounded even before the Fed had completed one-third of its eventual rate increases. The S&P 500 hit a low of around 3,500 in October 2022, 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% in November 2022 to 5.5% by July 2023. Intriguingly, after the Fed paused its hikes in July, the S&P 500 declined until October. 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% rate. In a full cycle, rates rose from 0.25% to 5.5% and were held there for a year. Yet the market 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% to 3% following a market crash. By March, Bear Stearns collapsed, prompting another 0.75% rate cut to 2.25%. In April, rates were further reduced to 2%; yet, the market spiralled downward between June and September when Lehman Brothers collapsed in September.
By October, rates were slashed to 1.5%, then to 1%, and by December, down to 0%-0.25%. Despite these drastic cuts, the 2008 crash ranks among the most severe in recent times, with the S&P 500 plummeting 50% from January to March, precisely when rates fell from 3.5% to zero. Far from boosting the market, the cuts could not even prevent a crash. The same pattern occurred in 2001: the Fed cut rates from 5% to 1.25% 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 dearer, it seems logical that markets would falter. Yet, other factors are at play, such as economic growth, 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 hikes rates incrementally. If growth remains solid, corporate profits rise, lifting stock prices. A strong economic growth can prompt further rate hikes. 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 condition, which is slower growth. When the Fed stops raising rates, it can be because 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—the market reacts negatively. Of the many forces shaping stock prices, economic growth, corporate profits and valuation are paramount. These deserve more attention than interest rate movements.
(This article first appeared in Business Standard newspaper)
Comments
pushpa_s
3 weeks ago
With so much of liquidity around, do not know if FED has the ability to control int. rates or inflation. Also, with China having a massive dollar chest can upset the apple cart.
Very good, and scholarly article. Debashish Dada is spot on, the last 50-60 years data prove it. However, with FED rate cut market bounces for short duration sucking in all the fence sitting retailers. In the end of 2007 there was unprecedented Euphoria, every second person aspired to make fortune in market. Aunties and Grandmas started giving stock tips . . . I think that societal exuberance is the tipping point and clear cut indication of bubble.
I already see that in market, everyone in IT industry holding stocks, those who never invested are now in market. Looks like we are in the flag end, when making money in stocks look very easy exit.
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I already see that in market, everyone in IT industry holding stocks, those who never invested are now in market. Looks like we are in the flag end, when making money in stocks look very easy exit.