In the past few months, the U.S. labor market has started to show unmistakable signs of softening; the unemployment rate has ticked up from a recent low of 3.4% to 4.2% today. Growth in monthly payrolls has slowed from an average of approximately 250,000 to below 150,000. These statistics have gotten the Federal Reserve’s attention; market expectations suggest that policymakers will lower the overnight lending rate at their next meeting for the first time in more than three years. The market also expects more rate cuts to follow and for the Federal Reserve to embark on a rate cutting cycle that will extend well into next year. Some investors are eager for this campaign to begin and are optimistic that lower rates will help drive stock market prices higher. What does the evidence say?
It is important to note that there are many drivers of stock market prices; interest rates are one. The main others are earnings, valuations, and sentiment. All else equal, lower interest rates do tend to act as positive force on stock prices through two mechanisms. First, by lowering the discount rate on future cash flows (dividends)…lower interest rates raise the present value of the stream of dividends that will be paid to shareholders in the future. This makes stocks worth more today. Secondly, lower rates reduce the relative attractiveness of competing asset classes, especially bonds and cash. To see how this works, imagine that you could earn 10% per year in a money market fund, or 15% annually on a five-year Treasury Bond. In that scenario, would you shift your portfolio allocation towards lower risk bonds and cash and perhaps hold less in higher risk stocks?
But, because interest rates are just one of several drivers of stock market returns, we can’t necessarily predict how stock prices will react to a new rate-cutting cycle. For example, if company earnings are disappointing, stocks could decline even as rates come down. This tends to happen early in a recession when rates are falling but corporate earnings are falling even faster. As evidence-based investors, we also know that stock prices quickly incorporate new information, including the expected path of future interest rates. This means that stock prices may not react at all to an expected rate cut, but rather react only to a true surprise (e.g. if rates move more or less than current expectations suggest).
We should also remember that the Federal Reserve controls only the overnight lending rate; longer term interest rates are set by the markets. While all rates have begun to fall recently, short-term rates have fallen the most; the relatively high overnight rate of 5.33% is starting to look like an outlier on the chart above. Although short-term rates may decline even further, stocks are considered a “long duration” asset; this simply means that they are more sensitive to long-term rates than short-term rates. Because long-term rates are not set by Federal Reserve policy, it becomes even more difficult to predict how stock prices will react to a new rate cutting cycle.
Due to recent softening in the U.S. labor market, the Federal Reserve is likely to lower short-term rates at their next meeting and continue lowering rates for months to come. Even if this expectation is proven correct, much uncertainty will remain in terms of the other drivers of stock market prices. Many investors may cheer for lower rates, but considering all of the lingering uncertainties, it probably doesn’t make sense to make changes to your long-term portfolio allocation based on Federal Reserve policy.