The relationship between rate cuts and the market

A version of this article originally appeared at cullenhilkene.com.

Recent discussions among market commentators are that the Fed is likely to pause its hiking cycle soon, if we haven't seen our last hike already.  In fact, many anticipate rate cuts before the end of the year.  As this news has filtered through the market, we've seen a recent pop in speculative, long-duration names - in other words, unprofitable stocks that struggle in high rate environments because their profitability lies far into the future.  The cash flows it will generate are valued less in present day terms because they must be discounted by a higher cost of capital, should the company survive to eventually see them. 

But is this reflexive reaction - speculative stocks going up when rates appear to be going down - the right one?  It raises the fundamental question: are rate hikes always good for stocks?

The stock market is a complex and constantly changing system that is influenced by a variety of factors. One of the most significant factors that can affect the performance of the stock market is interest rates, and in particular, rate cuts. Rate cuts are when central banks lower the benchmark interest rate in order to stimulate economic growth and encourage borrowing and investment. However, the relationship between rate cuts and the stock market is not always straightforward, and there are many instances where rate cuts have had little or no effect on the stock market, or have even had negative consequences.

One of the main ways that rate cuts can impact the stock market is by reducing borrowing costs for companies. When interest rates are lowered, it becomes cheaper for companies to borrow money, which can help them to expand their operations or invest in new projects. This increased investment can lead to higher profits and increased earnings per share, which can then lead to higher stock prices. In addition, lower interest rates can also stimulate consumer spending, which can lead to increased revenues for companies.

However, it is important to note that the relationship between rate cuts and the stock market is not always positive. In some cases, rate cuts can actually have a negative impact on the stock market. One of the main ways this can happen is through the devaluation of currency. When interest rates are lowered, the value of the currency can decrease, which can lead to inflation and reduced purchasing power. This can make imports more expensive, which can negatively impact companies that rely on imports or that compete with imported goods. In addition, lower interest rates can also lead to higher inflation, which can reduce the value of fixed-income securities and other investments that rely on stable inflation rates.

Another potential negative consequence of rate cuts is the impact on consumer behavior. When interest rates are lowered, it can be tempting for consumers to take on more debt, which can lead to financial instability and increased risk for the economy as a whole. In addition, lower interest rates can also lead to increased speculation and risk-taking in the stock market, which can lead to bubbles and market crashes.

Furthermore, the impact of rate cuts on the stock market can also be influenced by broader economic factors. For example, in times of economic uncertainty or recession, rate cuts may have little impact on the stock market, as investors may be more focused on minimizing risk and preserving capital. In addition, global economic factors such as trade tensions, political instability, and natural disasters can also impact the stock market, regardless of the actions of central banks.  To the extent that the Fed is pausing a hiking cycle or cutting in order to stimulate a stagnating economy, the turnaround for both businesses and their stock prices is often not immediate.

It is also worth noting that the impact of rate cuts can vary by sector and industry. For example, lower interest rates may benefit industries such as real estate and construction, which rely heavily on borrowing and financing, while industries such as utilities and consumer staples may be less affected by interest rates. Similarly, rate cuts may have a greater impact on small-cap stocks and emerging markets, which may be more sensitive to changes in interest rates than larger, more established companies.

In conclusion, while rate cuts can have a significant impact on the stock market, it is important to recognize that their impact is not always straightforward or predictable. While lower interest rates can stimulate investment and growth, they can also lead to inflation, currency devaluation, and financial instability. Furthermore, the impact of rate cuts can be influenced by broader economic factors, as well as by the specific industries and sectors in which companies operate. As such, investors should take a nuanced and careful approach when considering the impact of rate cuts on the stock market, and should always consider the broader economic and market context when making investment decisions.