In October, the average 30-year fixed mortgage rate hit 7.8%, which was the highest level in more than two decades. It caused a shock to the economy, mainly because rates were sitting at historic lows just two years ago.
But relief is on the way. According to Wall Street experts, the U.S. Federal Reserve is poised to cut interest rates six times in 2024, which could ignite a powerful move in the stock market. Below, I'm going to explain how we arrived at this point, and what it means for investors going forward.
Image source: Getty Images.
Here's why interest rates soared
The Fed has a mandate to maintain price stability, which means keeping the Consumer Price Index (CPI) measure of inflation at an annual rate of 2%. But in 2022 it hit a 40-year high of 8%, prompting the most aggressive monetary policy response in the Fed's history.
In just 18 months between March 2022 and August 2023, it raised the Federal Funds Rate from a historic low range of 0% to 0.25% to a much higher range of 5.25% to 5.50%, sending mortgage rates rocketing higher.
But what caused inflation to surge? Many economists point to the beginning of the COVID-19 pandemic in 2020, which prompted an unprecedented response from policymakers. It's a key reason interest rates were slashed to record lows, and it also triggered trillions of dollars in U.S. government stimulus spending.
Thankfully, by the end of 2021 the worst of the economic and health emergencies were over. But the ultra-stimulative policies from the Fed and the government contributed to the soaring prices that plagued consumers and businesses in 2022.
The stock market crashed in 2022
The benchmark S&P 500 (^GSPC 1.02%) index began to decline at the beginning of 2022 before the Fed even started raising interest rates. Investors knew the tick up in inflation would trigger a policy response, so they headed for the exits.
The S&P 500 had fallen by over 20% from its all-time high by mid-2022, meaning it technically entered bear market territory.
Data source: YCharts.
But as you can see from the above chart, the S&P 500 began to recover before 2022 was over, even though the Fed wasn't finished hiking interest rates. The stock market is a forward-looking machine, so when investors saw inflation was rapidly falling toward the end of 2022, they began placing bets the Fed would end its aggressive policy stance.
2023 brought far fewer rate hikes, and CPI inflation is on track to end the year at 3.5%. That marks a substantial drop from 8% in 2022, and it's clearly on the way back to the Fed's target of 2%. That sent the S&P 500 soaring 25.6% this year.
Wall Street experts are now betting the Fed will move in the other direction, with six interest rate cuts forecast for 2024.
History is clear: Falling interest rates are great for stocks
The Fed typically moves interest rates in increments of 25 basis points (0.25%). Therefore, six cuts would mean a reduction of 150 basis points from the current rate of 5.50%, bringing it down to 4.00%.
The last time the Fed cut rates that much in one year was in 2020, when it rapidly dropped the federal funds rate from 1.75% to 0.25%. There were other factors at play, including pandemic-related government stimulus, but the S&P 500 ended that year with a gain of 18.4%, despite the pandemic.
The Fed also cut rates from 3.50% to 0.25% in 2008 to fight the global financial crisis. While the S&P 500 ended that year down 37% amid the slew of bank collapses, it roared back with a 26.4% gain in 2009, which kicked off a nine-year win streak! The federal funds rate remained below 2.50% for that entire period.
There are many more examples throughout history, but it's certainly true the Fed cuts rates the fastest in the face of economic shocks. We are not fighting an unexpected crisis at the moment, which is why rates are forecast to settle at 4.00% in 2024 as opposed to much lower.
But why do falling rates often boost the stock market?
Businesses -- especially at the smaller end of the spectrum -- rely on a constant flow of fresh capital to grow and expand. That might come in the form of debt financing, or even equity financing, where a business is selling a stake in its future.
A business' borrowing power shrinks as rates increase, because serviceability costs occupy a larger share of its income. Similarly, the business might attract less revenue when rates are high because its customers have less disposable income, and that impacts how a potential equity investor calculates its valuation -- that's one reason many technology and software stocks have plunged since late 2021.
But lower rates can have the reverse effect by significantly reducing the cost of capital and boosting economic activity. Plus, investors earn a lower return from risk-free assets like cash and government bonds, so assets like stocks become more attractive.
Therefore, six rate cuts in 2024 could really light a fire under the S&P 500.
