How Stocks Perform When Interest Rates Fall

By TradeSmith Research Team

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Investors are slowly shifting their focus from rate hikes to rate cuts.

Many are anxious for the cuts to start because there’s a narrative going around that Fed rate cuts will buoy stocks.

Fed futures suggest rate cuts can come as early as next year.

Rising interest rates were one of the main forces that crushed stocks in 2022. The Federal Reserve went on one of the fastest hiking sprees in decades.

Now, if rising rates hurt stocks, you’d intuitively assume that falling rates would goose them. But is that really the case?

Let’s see the proof.

The results may surprise you.

To begin, the chart below maps out the Fed Funds futures through December 2024. Keep in mind these are only expectations and they change often.

The important piece is that future odds point to rate cuts beginning as early as June of next year:

Clearly, cuts are on the menu. So, the million-dollar question is simple: How do falling rates impact stocks?

For this historical study, I’m using the 3-month T-bill yield.

Since 1981, there’ve been seven distinct periods when rates were on the down-move. I’ve outlined those periods in yellow for this analysis:

Source: FactSet

This 40+ year lookback includes some of the biggest stock market events in recent history:

  • The 2020 pandemic
  • The Global Financial Crisis of 2007 -2008
  • The Early 2000s
  • The 1987 Crash and more
Given that T-Bill rates are at a level not seen since 2000, this is an opportune time to equip ourselves with cold hard facts.

We’ll run through two calculations to get a full-circle playbook:

  1. How do stocks perform as T-bill yields fall, peak to trough?
  2. How do stocks perform once rates bottom out?
Up first, you’ll see the seven prior periods listed. I’ve outlined the rate cycle peak, trough, and the change. Off to the right reveals the S&P 500 return as rates fall:

On the surface, a flattish return is the verdict. Important to note however is that these results heavily skew to hard landing episodes like the pandemic, GFC, and Tech bubble burst.

Those periods were brutal for markets as Fed Funds hit rock bottom rates of nearly zero.

I’m not in the hard landing camp. I see a soft landing as a more likely scenario given the resilient economy. The early ‘90s, a likely better parallel to today’s environment, reveal that stocks boomed during slumping rates with the S&P 500 ripping 42%.

The bottom line of this analysis is that falling rate climates tend to not benefit stocks.

But that is not the end of the story.

By now you should know I’m not the professor of doom. Rather, I focus on the opportunity.

The most important takeaway from the study is that once yields trough, stocks SOAR.

Once rates bottom out, we see one of the best rallies. The S&P 500 screams higher a year later with a stunning gain of +27%:

This, folks, is what you should be playing for… the coming almighty rally. Lower rates will eventually cause a monster tailwind for equities… spurring insane demand.

The kind of breakneck rally that sends the growling bears back into hibernation.

Whether you live in the soft landing or hard landing camp, it doesn’t matter. Keeping your bear-suit zipped too tight can be deadly!

Stocks are set to gain — just imagine what all-star growth companies will do — MEGA Rally.

Have guts.

Buy into the cuts!

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