The Fed's Rate Cuts: Impact on US Stocks

Alex Lee, Assistant Manager, Dealing | Contract for Differences

Alex thrives on the challenges of the financial markets, constantly seeking to understand intricate trading patterns and market movements. Outside of his professional responsibilities, he immerses himself in analyzing financial trends and staying abreast of the latest market developments. Alex finds the dynamic nature of economic forces fascinating and is passionate about navigating the ever-evolving landscape of trading.

The Federal Reserve’s (Fed) interest rate policies are a critical driver of US financial markets, with profound implications for stock valuations and sector performance. As the Fed signals a potential interest rate cut towards the end of the year in response to diminishing inflation rather than economic weakness, it is essential to understand how these changes could impact the US stock market.

The accompanying graph illustrates the current downward trend in inflation, highlighting a significant easing of price pressures. This trend is a key factor behind the Fed’s consideration of reducing interest rates however; with the recent strong retail sales report, this suggests that the economy is performing relatively well even as inflation recedes. Hence, a rapid rate cut is unlikely. According to a poll by Reuters, many economists and analysts are expecting a quarter-point drop at each of the next 3 remaining Federal Open Market Committee (FOMC) meetings. [1]

Japan’s economy and the interventions by the BOJ have often served as a reference point for major Central Banks globally when considering monetary policies to address economic downturns. Although Japan was not the first major economy to impose negative rates on deposits held by commercial banks, it was the first economy to sustain such a policy for an unprecedented eight years – a groundbreaking move in the history of central bank policy. However, even with a prolonged period of negative to zero interest rates, Japan’s economy failed to significantly boost domestic demand. Additionally, this policy has exerted downward pressure on Japan’s currency, especially as other nations like US had raised interest rates to combat inflation [14].

Interest rates, controlled by the Fed, directly influence the economy and financial markets. When the Fed adjusts its policy rates, it impacts borrowing costs, investment decisions, and investor behaviour. Currently, the Fed is gearing towards reducing interest rates due to a decrease in inflationary pressures. This shift has several potential consequences for the stock market:

1. Impact on Stock Valuations

Interest rates play a crucial role in determining stock valuations through the discount rate used in valuation models. Lower interest rates reduce the discount rate applied to future earnings, increasing their present value. This typically results in higher stock prices, particularly benefiting growth stocks that are valued based on future earnings projections. As the Fed approaches rate cuts, we can expect an upward adjustment in stock valuations, driven by the enhanced attractiveness of equities compared to other investments.

2. Enhanced Borrowing and Investment

A decrease in interest rates lowers the cost of borrowing for businesses, and can stimulate corporate investment in new projects, expansion, and capital expenditures. Companies may also be able to refinance existing debt at lower rates, improving their financial health and profitability. Increased business investment can lead to stronger economic growth and higher stock prices, as investors anticipate improved earnings and growth prospects.

3. Shift in Investment Preferences

As interest rates decline, the yields on newly issued fixed-income securities such as bonds decrease. This shift often prompts investors to reallocate their portfolios towards equities in search of better returns. The increased demand for stocks can drive up their prices, benefiting the broader market. This dynamic is particularly relevant in the current environment, where the Fed’s rate cut is expected to make bonds less attractive relative to stocks.

Different sectors of the economy respond variably to changes in interest rates. With the Fed’s anticipated rate cuts, specific sectors are likely to experience distinct impacts:

• Financial Sector: Banks and other financial institutions may face mixed effects. While lower interest rates can compress net interest margins—reducing the difference between the rates charged on loans and paid on deposits—rate cuts can also stimulate loan demand and economic activity. Additionally, easing financial conditions can improve investor sentiment towards financial stocks.
• Real Estate: The real estate sector is likely to benefit significantly from lower interest rates. Reduced mortgage rates can increase housing affordability, boost home sales, and enhance property values. Real estate investment trusts (REITs) and housing-related stocks typically see gains in a lower-rate environment due to increased demand and cheaper financing for property acquisitions and developments.
• Utilities: Utilities, known for their stable dividend yields, generally perform well in a lower interest rate environment. As bond yields decline with falling interest rates, utilities become more attractive to income-seeking investors. This trend can lead to higher stock prices for utility companies, which benefit from both lower borrowing costs and increased investor interest.
• Technology: The technology sector, which thrives on growth and innovation, stands to gain from rate cuts. Lower interest rates reduce the cost of capital for tech companies, facilitating investment in research and development, acquisitions, and expansion. Additionally, the increased valuation of future earnings, driven by lower discount rates, supports higher stock prices for technology firms.
• Consumer Discretionary: The consumer discretionary sector, which includes retail and leisure industries, often benefits from lower rates as consumers gain more purchasing power and access to credit. This can lead to increased spending and higher revenues for companies in this sector. Additionally, lower borrowing costs can help discretionary companies finance expansion and operational improvements.
• Consumer Staples: While the consumer staples sector is generally less sensitive to interest rate changes due to the essential nature of its products, it can still benefit indirectly from a lower rate environment. Increased economic stability and consumer spending power can support steady demand for staple goods, contributing to stable stock performance.

The Fed’s meetings on the following dates will be crucial in shaping future interest rate policies:

• 17 Sep, Tue
• 18 Sep, Wed
• 6 Nov, Wed
• 7 Nov, Thu
• 17 Dec, Tue
• 18 Dec, Wed

The anticipated reduction in interest rates by the Fed, prompted by diminishing inflation, could create a favourable environment for the US stock market. Lower rates may enhance stock valuations, stimulate corporate investment, and shift investor preferences towards equities. However, the impact will vary across sectors, with notable effects anticipated in financials, real estate, utilities, technology, and consumer-oriented industries.

Investors should carefully consider these sector-specific dynamics when adjusting their portfolios. Understanding how interest rate changes affect various aspects of the market, allows investors to make more informed decisions and better navigate the evolving economic landscape. Staying informed and adaptable will be key to capitalising on emerging opportunities and managing potential risks as the Fed continues to refine its policies.

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References

[1] https://www.reuters.com/markets/rates-bonds/fed-deliver-three-25-quarter-point-rate-cuts-this-year-recession-unlikely-2024-08-19/

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