For the last two years, market sentiment has largely been dictated by interest rates. Stocks crashed in 2022 as the Federal Reserve began a campaign to raise interest rates faster than it has in more than a generation to bring inflation under control.
Since its first hike in Mar. 2022, the central bank has lifted the federal funds rate from near zero to 5.25% to 5.50%, and rate hikes have continued in 2023 even as the benchmark rate seems to be plateauing at its current level. Still, Federal Reserve Chair Jerome Powell has refused to rule out future hikes, insisting that the Fed's most important objective is to bring inflation down to its target of 2%.
While stocks have risen in 2023 as a feared recession never arrived and new artificial intelligence developments stoked interest in what could be the next major technology platform, interest rate movements have continued to hang over the stock market, often leading to big swings in the S&P 500 when the Fed announces a rate hike decision or on other news related to interest rates. For example, earlier in November, stocks soared after the October Consumer Price Index report showed inflation was lower than expected, making it less likely the Fed will raise interest rates again, even though it forecast one more hike back in September.
Now, a new report shows that not only could interest rate hikes be done at this point, but the Fed could soon lower the key federal funds rate.
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Could the Fed turn dovish?
According to CME Group data published in The Wall Street Journal, investors now believe it's more likely that the Fed will lower rates than hold them steady over the next six months. In fact, interest rate futures pointed to an approximately 60% chance that the Fed will lower rates by 0.25% by its May 2024 meeting, a substantial increase from a month ago when the same data showed just a 29% chance of a rate cut from the Fed.
That data also shows the market is expecting four rate cuts by the end of the year, meaning the fed funds rate would fall to 4.25% to 4.50% by the end of 2024. In line with that forecast, interest rates on longer-term treasuries are coming down but stocks have surged this month, showing that investors are increasingly betting on a soft landing, meaning the Fed can bring inflation down to its 2% target rate without causing a recession.
Why falling rates matter
Rising interest rates tend to be bad for stocks because they make bonds more attractive by comparison, and they also make it more expensive for businesses to borrow money to invest in growth. For growth stocks, higher rates also raise the discount rate in discounted cash flow models, which typically lowers their valuations.
On the other hand, falling interest rates tend to support money moving from bonds back to stocks and generally support higher valuations in the stock market, as well as increased business investment. If the economy remains stable and can avoid a recession, lower rates should support a continued rally in the stock market next year.
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Circle this date on your calendar
The Federal Open Market Committee (FOMC) will hold its next meeting in mid-December, issuing its interest rate decision on Dec. 13. The Fed will also provide its "dot plot" forecast, giving investors further insight into where it sees interest rates going in 2024. As of September, it expected the fed funds rate to finish 2024 at 5.00% to 5.25%, indicating that rates would stay higher for longer than previously expected.
If the Fed chooses to keep rates steady in December and forecasts a sharper decline in interest rates in 2024, stocks could soar on the news, reflecting the same pattern we saw on Nov. 14 when the Bureau of Labor Statistics reported a weak inflation report.
Investors can prepare for falling interest rates by looking to small-cap stocks like those in the iShares Russell 2000 ETF, real estate plays like Redfin, regional banks like Truist Financial, and other sectors that have been hit hard by rising interest rates. If the forecast above is accurate, those sectors look poised to lead the current rally in stocks into 2024.
