Published September 20, 2024
Now that the Federal Reserve has shifted direction and begun lowering short-term interest rates, there is much discussion about how markets react as the rate-cutting moves forward. It turns out there are three distinct scenarios, historically, for the Fed to shift to a rate-reduction mode. Most prominent is to fight a notable slowdown in economic activity and either stave off or minimize the impact of a recession. This can either be the “panic” cut such as we saw in the “covid” summer of 2020, or in response to a mounting economic storm such as the onset of the 2008 financial crisis (which really kicked off in Summer 2007). The third and more benign scenario is where the Fed is simply “normalizing” interest rates. This occurs when the Fed reaches a point where their prior goals/targets have been met and they are unwinding that “medicine”, whether it be stimulative or contractive.
With no signs of an impending recession, the Fed certainly seems to be in this normalizing mode as they declare victory in bringing inflation back down and shift to driving interest rates to some “normal” level. That normal level should be somewhere in the range of long-term historical rates of around 2-3% for short-term notes and 4-5% for longer-term notes.
The market has already done the Fed’s work for the out years of the yield curve as long-term mortgage rates are back in the 6-7% range. The yield curve has returned to its typical upward slope for years 3 and beyond. Now, the Fed will be focused on the pace of bringing the left-hand side of the curve below down below that 3-year note level (currently 3.5%). That requires inflation to continue dropping to 2% or lower.
The table below shows what the Normalization mode for the Fed historically means for the stock market. The results are favorable.
Market Update
This was a market week dominated by Wednesday’s Federal Reserve announcement. Stocks largely ran in place ahead of the announcement closing little changed Monday, and giving up a morning advance Tuesday to close with little movement once again. Investors were split on whether the Fed would cut interest rates by 0.25% or 0.50%. So they waited until they got word before committing. Wednesday brought the announcement of the larger 0.50% cut and stocks initially jumped before giving back all of that move by day’s end. Through Wednesday, the S&P 500 was flat for the week. The reaction would arrive a day later. Thursday brought a strong rally as investors digested the Fed’s cut and path for future rate reductions.
The growth-focused Nasdaq 100 (QQQ) gained +2.5% while the S&P 500 gapped up to a new record high. The gains were not added to in Friday’s trade. Small-cap stocks gave back -1% Friday while the larger cap indexes dipped -0.2%. Still, that left the S&P 500 at a record high at week’s end with a +1.42% weekly gain. The Nasdaq 100 (QQQ) posted a +1.49% move. Small-cap stocks rose +2.19% for the week.
Warm wishes and until next week.