The effect of previous Federal Reserve interest rate cuts on the S&P 500 paints a murky picture.
Federal Reserve Chairman Jerome Powell has cited two factors that could lead to lower interest rates. The first is falling inflation, which could move closer to the Fed’s 2% target. The second is a weakening jobs market.
Both boxes are now checked. The Fed’s preferred inflation gauge, the personal consumption expenditures (PCE) price index, fell to 2.5% in June. July’s jobs numbers were weaker than expected.
The likelihood of a short-term interest rate cut has increased. But will stock markets soar if the Fed cuts rates in September? Here’s what history shows.
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Looking Back
The Fed has cut interest rates 28 times this century. Six of those rate cuts came in fits and starts.
In early 2001, the Fed began a series of 11 rate cuts. Initially, these cuts were primarily driven by the U.S. recession that followed the bursting of the dot-com bubble. The terrorist attacks of September 11, 2001, were another catalyst for the Fed’s action. How did the stock market react? Not very well.
^SPX data by YCharts.
Although this recession ended in November 2001, the recovery that followed was not very strong. The Fed intervened with another rate cut in November 2002. S&P 500 The index did not react immediately and even fell in the first quarter of 2003. However, the index rebounded sharply in March. The Fed cut rates again by 0.25% in June 2003. Once again, stocks did not move much immediately. However, the upward trend quickly resumed.
^SPX data by YCharts.
Four years passed without interest rates changing. However, the housing market crash in the second half of 2007 prompted the Fed to shift into high gear. It cut rates in September 2007 and then six more times through April 2008. These measures were not enough to prevent a significant drop in the S&P 500.
^SPX data by YCharts.
Then, in October 2008, the stock market crashed. The U.S. economy declined so badly that it was called the Great Recession. The Fed cut interest rates by 0.5% twice in October and then by 1% in December. The S&P 500 initially plunged, but rebounded starting in March 2009.
^SPX data by YCharts
More than a decade has passed. The U.S. economy and stock market have regained momentum. However, in August 2019, the Fed began what Powell called a “mid-cycle adjustment.” It cut rates by 0.25% three times, with the last cut occurring on October 31, 2019. The first cut did not seem to provoke a reaction in the stock market. However, the S&P 500 took off after the Fed’s decision in October.
^SPX data by YCharts.
The COVID-19 pandemic prompted the Fed to cut rates twice in March 2020. Although the S&P 500 initially fell, it quickly rebounded.
^SPX data by YCharts.
Why mixed results?
As we’ve seen, Fed rate cuts have had mixed effects on stock markets in the past. Why hasn’t the S&P 500 consistently surged on what should have been considered good news by investors? It’s complicated.
In some cases, the Fed’s actions have simply not been enough to immediately offset severe economic or geopolitical challenges. For example, rate cuts were not enough to calm investors after the September 11 attacks or the 2008 stock market crash.
Other times, investors might have decided to wait and see whether interest rate cuts would make a big enough difference to warrant further optimism.
In addition, the Fed often announces its decisions well in advance. When investors anticipate a rate cut, they can start buying before it happens. The rate cut could then become a virtual non-event for the stock market.
Good investment ideas if a rate cut is on the horizon
The history lesson is simple: Don’t bet on stocks rising just because the Fed cuts rates. It may, but it doesn’t have to. However, I think there are some good investment ideas if a rate cut is indeed on the cards (whether in September or in the months after).
Long-term bonds typically rise when interest rates fall. Vanguard Long-Term Bond ETF (BLV 0.90%) is a smart way to play this trend. This exchange-traded fund (ETF) holds nearly 3,100 long-term bonds and has a low annual expense ratio of 0.04%.
I also like the Vanguard Small Cap Value ETF (VBR 0.14%)Small-cap stocks often rise when rates fall. Small companies often have a higher percentage of debt than larger companies. Lower rates reduce their interest costs.
Keith Speights holds positions in Vanguard Small-Cap Value ETF. The Motley Fool has no positions in any of the stocks mentioned. The Motley Fool has a disclosure policy.
