Other Rate Cuts Are Unlikely. Why Stock Markets Will Benefit.

May 23, 2023
Stephanie Bedard-Chateauneuf
Wall Street is ready to see the Federal Reserve end its aggressive rate-hiking cycle, which has bruised markets and put investor morale to the test.

Wall Street is ready to see the Federal Reserve end its aggressive rate-hiking cycle, which has bruised markets and put investor morale to the test. Although a pause in rate hikes appears inevitable, interest rate decreases may be further away than some expect.

After a tough 2022 marked by sustained inflation, Federal Reserve interest rate rises, Covid shutdowns, and geopolitical worries, the stock market has been resilient this year.

Nonetheless, markets have been on high alert for hints that the central bank may slow its rate hikes. This May, the Fed raised rates by a quarter point for the eighth time in a row. The Fed also hinted at a pause, increasing expectations that it will leave rates constant at its next meeting in June and drop rates as soon as July.

However, experts believe that the Fed will not cut rates so fast, at least while the economy remains strong (all bets are off if the US defaults on its debt). They argue that a halt in rate hikes could be better for stock than a cut.

The Fed probably won’t lower interest rates in July

Experts believe the Fed will not decrease rates anytime soon for two reasons: the economy has remained healthy, and inflation is persistently high.

Despite price stability, inflation is significantly above the Fed's 2% target. The Fed's favorite inflation gauge, the Personal Consumption Expenditures price index, climbed 4.2% in the year ended March.

Meanwhile, unemployment in the United States is at an all-time low. The housing market in the United States is cooling, but low inventory and persistent demand are driving up property prices in some areas.

In other words, there is nothing — at least not yet — to persuade the Fed to change course and cut interest rates.

The Fed last lowered interest rates following an emergency meeting in March 2020, when the Covid-19 outbreak pushed US markets into their first bear market in 11 years and sparked fears that the global economy would enter a deep recession.

The failures of Silicon Valley Bank, Signature Bank, and First Republic Bank this year have raised concerns that the banking sector will experience further turbulence and credit standards will tighten. However, the volatility has largely been limited to regional banks, and financial and economic officials have emphasized that the banking industry is still stable.

According to Liz Ann Sonders, chief financial strategist at Charles Schwab, the central bank would have to decrease rates in July if the banking sector took a major turn for the worst, the job market imploded, or the economy took a similar plummet.

Would a cut in July help stocks?

Even if the Fed cuts rates soon, an instant bull run is not certain.

Stocks have historically performed mediocrely following a switch to rate reduction versus a pause: According to Credit Suisse, the S&P 500 has historically risen 16.9% in the 12 months after the last hike of a Fed rate cycle and fell 1% in the 12 months following the central bank's first rate decrease, according to a May 9 report.

Cutting interest rates too soon might have serious ramifications for the economy.

Between 1972 and 1974, then-Fed Chair Arthur Burns drastically increased interest rates. He then reduced them as the economy contracted.

When inflation rose later, the Paul Volcker-led Fed took severe measures to curb it by raising interest rates. By July 1981, effective Fed funds rates had surpassed 22%, and the central bank's relentless tightening had contributed to back-to-back recessions with unemployment rates as high as 10%.

Powell addressed the gaffes in a speech in Jackson Hole in August. Since then, the Fed has indicated that it is unlikely to decrease rates this year and has underlined its commitment to containing inflation.

That's not to suggest a Fed rate drop this year is out of the question, according to Nicole Webb, senior vice president at Wealth Enhancement Group. She believes the Fed will eventually want to cut rates, but not at the historical rate at which it has raised them over the past year.