Introduction to Interest Rates and the Stock Market
The Federal Reserve is expected to cut interest rates at its September 2025 policy meeting due to weak U.S. employment data and easing inflationary pressures. This move is anticipated to affect the stock market, but the extent of its impact is uncertain. Conventional wisdom suggests that rate cuts typically benefit the stock market by stimulating economic growth and boosting stock prices. However, the reality is more complex, and the impact of rate cuts on equities varies depending on the economic environment.
The Impact of Rate Cuts on the Stock Market
The performance of past rate-cutting cycles is a testament to this complexity. For instance, in 1995, the Morningstar US Market Index surged over 21% in the 12 months following the start of Fed easing, achieving a rare soft landing. In contrast, in 2001, the same index fell more than 10% after the Fed began cutting rates as the dot-com bubble burst. This ambiguity highlights the need for investors to consider the broader economic context when anticipating the effects of rate cuts.
Understanding the Reasons Behind the Rate Cut
According to Lara Castleton, U.S. Head of Portfolio Construction and Strategy at Janus Henderson Investors, understanding why the Fed is cutting rates is crucial for gauging future market direction. The market’s reaction depends on whether the rate cut is seen as a reactive move to an impending recession or a proactive measure to engineer a soft landing. The size of the first cut is also closely watched, as a 50-basis-point reduction could be interpreted in different ways, influencing market reactions.
Earnings Growth and Interest Rates
Research indicates that earnings growth is a more reliable predictor of stock market returns than interest rates alone. When accelerating earnings growth coincides with falling rates, the S&P 500 has delivered an average return of 14% over the following 12 months. This is significantly higher than the returns when rates fall alone or when earnings decline alongside rates. The recent Q2 earnings season showed over 10% annualized earnings growth for constituents of the Morningstar US Market Index, which is a positive signal.
Volatility in the Market
Market expectations for the rate cut have been highly volatile, with the probability of a 50-basis-point cut changing rapidly. Despite the Fed’s actions, market anxiety persists due to concerns about the economy slowing and the potential for a recession. The market’s 24% gain over the past 12 months has already partially priced in the rate cuts, which may limit further upside. However, achieving a true soft landing could still open new pathways for stock gains.
Preparing for Different Outcomes
Investors are advised to position their core portfolios for two possible scenarios: a hard landing and a soft landing. Defensive stocks and rate-sensitive REITs can serve as buffers in case of a hard landing. If a soft landing is achieved, small-cap stocks, which have underperformed in recent years, could see a breakout due to their attractive valuations compared to mega-cap tech stocks. Rate-sensitive sectors such as financials and real estate are also likely to benefit from lower rates.
Conclusion
In conclusion, the impact of the Federal Reserve’s interest rate cuts on the stock market is complex and depends on various factors, including the reasons behind the cut and the state of earnings growth. While rate cuts can stimulate economic growth and boost stock prices, they do not guarantee a stock market rally. Investors should prepare for both a hard landing and a soft landing by diversifying their portfolios with defensive stocks, small-cap stocks, and rate-sensitive sectors. By understanding the complexities of interest rates and their effects on the stock market, investors can make more informed decisions and navigate the volatility of the market effectively.
