What to Expect When You’re Expecting...Rate Cuts
“When it comes to the pricing of financial assets, perceptions count. Reality is of lesser consequence. So even if an anticipated event never occurs, it matters little. The market has already moved on what it thought would happen.”
Charles E. Babin & William J. Donovan
Investing Secrets of the Masters (1999)
And just like that, 2024 is off with a bang. By and large, market performance came in well ahead of expectations, culminating in one of the best first quarters of the last decade (S&P 500 +10.2%; DJIA +5.6%; NASDAQ +9.1%).
But what’s behind this momentum? Keen market observers would agree that it is possible—likely even—that a meaningful portion of the stock market’s gains have been influenced by investors’ eager anticipation of Federal Reserve monetary policy actions, namely potential cuts to the Fed Funds Rate. As the benchmark short-term interest rate at which banks can lend reserve balances to each other, the Fed Funds Rate has wide-ranging implications in financial markets and, in turn, can have a significant impact on consumers. Coming out of the depths of the pandemic, the Federal Reserve (“the Fed”) raised (or hiked) its short-term policy rate in response to sharply rising inflation, believing higher interest rates would help cool borrowing and spending and subsequently stabilize the prices of goods and services.
In total, the Fed implemented 11 straight rate hikes between March 2022 and July 2023, pushing the Fed Funds Rate up from a target range of 0.00 - 0.25% (where it had previously sat unchanged for two years) to the current range of 5.25 - 5.50%. And with it, so rose nearly all other institutional and consumer interest rates, from auto loans and mortgages to returns on interest-paying financial products, such as money market funds and certificates of deposit (Figure 2). 
Now, with the inflation cooling and economic conditions moderating to some extent (though still relatively robust), the Fed may be on the verge of partially reversing its monetary policy by beginning to lower the Fed Funds Rate, which it has held steady for nearly a year. As a result, consumer and corporate borrowing may become more tenable again as the tide of monetary policy influences all “boats,” with mortgage and loan rates, credit card interest, and, conversely, interest paid on cash deposits and savings, all primed to decline. That said, correlation does not equal causation, and while we may observe changes in interest rates occurring roughly in-line with monetary policy actions, the timing of these fluctuations is often a “chicken or the egg” scenario.
Generally speaking though, lower borrowing costs should incentivize consumers and businesses to spend more, thus injecting capital into the economy and generating economic growth—a potential tailwind for the stock market as well. As we have discussed in the past, markets are inherently forward-looking, and with the Fed’s own internal projections currently indicating three 25 basis point (or 0.25%) rate cuts1 before the end of this year (Figure 3), stocks may be rising ahead of any actual policy actions. Additionally, some investors may be strategically swapping cash holdings for stocks and higher-yielding bonds now in anticipation of declining interest rates in the future so as to lock in portfolio allocations “ahead of the game.” When rate cuts finally materialize, the market’s reaction could be more muted.
*Projections are as of the Federal Reserve’s Open Market Committee meeting on March 20, 2024. Chart shows each meeting participant’s expectation of the Fed Funds Rate target level at the end of 2024, grouped by range.
Lower policy rates—particularly the timing and magnitude of cuts—may not be a forgone conclusion, however. History has shown that the Federal Reserve’s policy actions fall on a spectrum from preemptive to urgent based on broader economic conditions, and the stock market’s reaction to such moves is not always straightforward (and often influenced by additional factors). Investors are apprehensive of surprises in particular. The Fed’s next move must be carefully choreographed and, ideally, well-telegraphed in advance. But assuming the course of rate cuts plays out as expected, the market appears poised to reward patient stakeholders.
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1 Absent more tumultuous economic events that require the Fed to effect policy changes quickly, adjustments to the Fed Funds Rate are typically made in stepwise 25bps (0.25%) increments.