In late March, the Federal Reserve said it would leave the federal funds rate at a 23-year high, but it also signaled expectations to cut rates three times this year. The central bank wants to be confident inflation is moving sustainably lower toward its 2% annual growth target rather than prematurely lowering interest rates.
Recent economic data shows inflation remains uncomfortably high, but the market is still anticipating one to two quarter-point rate cuts will happen this year.
The prospect that interest rates will be lowered sooner rather than later is one of the reasons the equity market rallied more than 25% from late October through mid-April. However, lowered rate-cut expectations following a red-hot March Consumer Price Index (CPI) report has more recently weighed on the equities market.
But why are interest rates so important to the stock market and stock prices in general?
There are several reasons for this, but the most fundamental one is that rate cuts promote broad economic growth and corporate profits. Another reason is that they help investors make more money. Let's take a closer look.
How interest rates impact stock prices
Corporate profits are closely tied to interest rate movements. Many companies borrow for the short term with debt that resets each quarter. The interest on these loans is based on a rate index that mimics changes set by the Federal Reserve using the federal funds rate. The federal funds rate is the interest rate on short-term interbank loans and is typically what is being referred to when folks talk about "rate cuts."
As a result, even the anticipation of a lower federal funds rate by the Federal Reserve can move other interest rates lower. This, in turn, helps boost general economic growth and corporate profits.
For example, inflation improved throughout 2023, falling to 3.4% by the end of December from 6.4% in 2022. This had the result of lowering a number of different key interest rates throughout the year. For example, the 2-year short-term Treasury yield, which is one interest rate the government uses to borrow money, was last seen at 4.9%, down significantly from its October 2023 peak near 5.24% – a period that coincided with the stock market's most recent lows.
This decline in interest rates occurred even as the Fed kept the federal funds rate at a range of 5.25% to 5.5%. Moreover, gross domestic product (GDP) excelled in Q4, growing at an annual rate of 3.4% according to the Bureau of Economic Analysis. And for all of 2023, the GDP growth rate was 2.5%. This indicated the economy was strong enough to withstand higher interest rates.
Yet at the end of 2024, futures traders were pricing in expectations the first quarter-point rate cut would come in March. In other words, the market's anticipation that the Fed would lower rates had a positive effect stock prices, since it assumes that a company's earnings per share and profits will rise as borrowing costs decline.
In effect, lower interest rates lead to higher price-to-earnings metrics and vice versa. But this is not the only way they help the market.
Interest rates and Wall Street
Many trading departments on Wall Street (i.e., hedge funds, prop desks at mainline brokerage firms, mutual funds, etc.) use extensive amounts of leverage to purchase their positions in the market. So lower short-term interest rates improve the costs of this borrowing activity. This, in effect, can help boost profits and potentially have a follow-on effect of increasing share prices.
In addition to stocks, these positions can also include other leveraged securities markets. Think Treasury notes or secondary loan markets such as collateralized loan obligations (CLOs). For example, the secondary market in CLOs, which are essentially bank loans of major corporations that trade on the market, become more liquid and profitable with lower rates.
The bottom line is that interest rate movements can dramatically affect the borrowing costs of large Wall Street firms. By having lower borrowing costs, these companies can improve their profits.
As a result, trading institutions tend to push up prices when interest rates and Treasury yields fall. The opposite also occurs when rates rise. But investors have plenty to be excited about this year given the market anticipates lower inflation and lower interest rates as a result. This will potentially lead to higher stock prices, higher bond and note prices (and lower yields).
