‘Why’ the Fed cuts rates matters as much as ‘when’ and ‘by how much’

Over these past few months, much speculation has been about when the Federal Reserve will start to cut rates. Coming into 2024, some thought the first rate cut could come as soon as March. Now, most estimates predict it won’t happen until June or possibly July. However, with all this speculation about when the Fed will cut rates, an equally important consideration is why they will cut them.

After all, the underlying economic scenario behind the rate cuts matters most to financial markets. It’s rare for rate cuts solely due to reduced inflation concerns—as opposed to cutting rates in response to economic slowdown or an external event like war, the Covid pandemic or a financial crisis. However, this ideal soft landing scenario may be within reach and is more likely than a severe slowdown.

The most likely outcome: Rate cuts in response to lower inflation
Although the unemployment rate has ticked up slightly and the manufacturing sector has weakened somewhat, the U.S. economy is still strong, surprising everyone, especially given how quickly the Fed has raised rates. For these reasons, it seems most likely that if the Fed cuts rates in June or July, it will be because inflation has come down. We saw this scenario play out from July 1995 to February 1996, during which time the Fed eased monetary policy simply because of reduced inflation concerns, rather than additional external factors.

If easing inflation is the prompt for the Fed to cuts rates in this cycle, that environment would be positive for the stock market in general, with some sectors benefitting more than others. For example, financial stocks, real estate investment trusts (REITs), and commodity- and energy-based stocks are relatively more highly correlated with economic growth. Small-cap and mid-cap indices with exposure to those cyclical sectors would likely also benefit more than many large-cap indices that are dominated by technology stocks. However, that’s not to say that the latter would go down, rather, that markets would be less dominated by the performance of big-name tech stocks as they are now.

That all said, even if this rate-cut scenario occurs, it’s important to temper any expectations. A cut of 25 basis points (one-quarter of a percentage point) won’t make a large difference in economic conditions, especially since the Fed will be starting at a high Federal Funds rate (5.25% to 5.5%). Moreover, even if the Fed cuts rates three times this year at 25 basis points each, as they’re currently expected to do, the resulting Federal Funds rate would still be considered restrictive. As a result, stocks would benefit only incrementally.

Looking at other investments and savings vehicles, the bond market has already priced in three rate cuts of that size this year, so yields are unlikely to drop further for bonds with maturity dates of five years out or longer, if the Fed does as expected. However, anything tied to overnight rates such as the interest paid on savings accounts and the yields on money market funds and short-term Treasuries will drop as soon as the Fed cuts rates. Meanwhile, the rate cuts would be positive for credit spreads, which would improve the performance of corporate bonds and make the yield curve less inverted.

A worse scenario: rate cuts due to severe economic slowdown
Although the labor market is healthy right now and U.S. economic growth is strong, a soft landing is not a certainty. It’s important to consider what could happen if the Fed has to cut rates in response to a severe slowdown in economic growth. In that scenario, there would be a sharp deterioration in the labor market, with the unemployment rate and jobless claims rising substantially.

A downturn in the labor market would make the Fed concerned that the economy is slowing down much faster than what they’re forecasting, so they would cut rates in response. We saw this scenario happen from September 2007 to December 2008. During that period, the Fed initially cut rates in response to financial stress and weakening growth in the economy, and then had to ease financial conditions further in response to the global financial crisis. Severe economic slowdown is usually not a good environment for stocks, which would go down even though the Fed is cutting interest rates to stimulate economic growth.

U.S. election also a factor
Finally, although the most recent economic news has focused on the Fed and how their next move will impact financial markets, it’s also important to keep in mind that we’re in a presidential election year. Later in the second quarter, the markets will be paying more attention to whichever presidential candidate is ahead in the polls, and the economic implications of their proposed policies. That impact will continue through the remainder of 2024.

And so, while the Fed’s decision to cut rates will matter to financial markets, any slow, incremental rate changes will have less of an impact than the overall state of the U.S. economy. That’s why it’s important to stay aware of the economic data released each month, rather than just focusing solely on monetary policy moves one way or another. As part of our process, the investment management team at BOK Financial monitors economic data and news so that we can keep you informed about what may affect the economy—and your investments.