Interest Rates Recently Did Something They Haven't Done Since March 2020, and It Could Trigger a Big Move in the Stock Market

The U.S. Federal Reserve has two main objectives: Keeping the Consumer Price Index (CPI) measure of inflation increasing at an annualized rate of 2%, and maintaining full employment in the economy (although there is no specific target for the unemployment rate).

The Fed adjusts the federal funds rate (overnight interest rate) to help it achieve those objectives. For example, it embarked on one of the most aggressive campaigns to hike interest rates in its history in 2022, when the Consumer Price Index (CPI) surged to a 40-year high of 8%.

Thankfully, inflation has cooled significantly since then, which allowed the Fed to cut interest rates in September for the first time since March 2020. It followed that up with another cut in November, and there could be more on the way.

Conventional wisdom suggests lower interest rates are great for the stock market, but history points to a potential downturn in the S&P 500 (SNPINDEX: ^GSPC) in the near term.

Interest rates could fall further in 2025 and 2026

The surge in the CPI during 2022 was driven by a cocktail of inflationary pressures:

• The U.S. government injected trillions of dollars into the economy throughout 2020 and 2021 to counteract the negative effects of the COVID-19 pandemic.
• The Fed lowered the federal funds rate range to a historic low of 0% to 0.25% in 2020. It also poured trillions of dollars into the financial system through quantitative easing (QE).
• Production facilities shut down all over the world to stop the spread of COVID-19, which led to shortages of many consumer goods and sent prices soaring.

The Fed started increasing rates in March 2022, and by the last hike in August 2023, the federal funds rate was at a range of 5.25% to 5.5%. That marked a two-decade high, which was necessary to cool the economy down after two years of stimulative policies.

Thankfully, it worked. The CPI cooled to 4.1% in 2023, and it came in at an annualized rate of 2.6% in October 2024 (the most recent reading). In other words, the Fed's 2% inflation target is within reach.

That gave the Fed's Federal Open Market Committee (FOMC) confidence to slash the federal funds rate by 50 basis points in September, followed by another 25 basis points in November. The FOMC's own projections suggest another 25-basis-point cut might be on the way in December, followed by 125 basis points' worth of cuts during 2025 and 25 basis points' worth of cuts in 2026.

The FOMC's forecast is dynamic, meaning it could change over the next few months as new economic data comes in. However, as things currently stand, the federal funds rate could be under 3% in around two years from now.

The S&P 500 often declines after rate cuts

Lower interest rates can be great for the stock market for a few reasons. They allow corporations to borrow more money to fuel their growth, and it reduces their loan servicing costs, which directly boosts their earnings. Additionally, falling rates can drive down the yield on risk-free assets like cash and U.S. Treasury bonds, which pushes investors to buy stocks instead.

However, going back to the year 2000, every rate-cutting cycle by the Fed was followed by a short-term correction in the stock market. The below chart, which overlays the federal funds rate (upper limit) with the S&P 500, illustrates this:

Target Federal Funds Rate Upper Limit data by YCharts

The S&P 500 always trends higher over time, so this apparent correlation isn't a reason for investors to panic. Considering the Fed usually cuts rates because the economy is showing signs of weakness, that is probably the reason for the stock market declines rather than the rate cuts themselves.

The Fed slashed rates in the early 2000s because the dot-com tech bubble burst, which pushed the economy into a recession. It then cut rates in 2008 because of the global financial crisis, and in 2020, the pandemic was the trigger for lower rates.

The S&P 500 is actually trading near a record high right now even after the Fed's recent cuts, which is a great sign, and there doesn't appear to be an economic crisis on the horizon.

There are signs of economic weakness, and a recession wouldn't be unusual

The U.S. economy is in good shape right now, but there are some cracks forming. For example, the unemployment rate has ticked higher to 4.1% after starting the year at 3.7%. Further deterioration in the jobs market can lead to weakness in consumer spending, which can hurt economic growth.

Plus, throughout history, periods of rising interest rates have often been followed by recessions. It makes logical sense because the Fed hikes rates to put the brakes on the economy, and economic weakness can quickly overshoot and turn into something worse.

The below chart shows the effective federal funds rate going back to the 1960s, with recessionary periods highlighted in gray. By my own observation, a recession eventually struck the U.S. economy practically every single time the Fed hiked rates:

Effective Federal Funds Rate data by YCharts

Therefore, if there is a correction in the S&P 500, it's unlikely to be due to interest rate cuts, but rather it might be because of the Fed's rate hikes that are having a delayed slowing effect on the economy.

Stock prices are driven by corporate earnings, and it's difficult for companies to grow during periods of economic weakness. Without earnings growth, the S&P 500 will generally trade lower. Plus, the S&P is trading at a historically expensive valuation right now, which could lead to a much steeper correction if one does occur.

With all of that said, investors shouldn't rush to sell stocks. Instead, they should mentally prepare for a potential downturn and create a plan to buy stocks if it comes. After all, history proves the S&P 500 always trends higher over the long term.

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Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.