Why Investors Could Be Okay With No Rate Cuts This Year

Federal Reserve - Shutterstock photo
Credit: Shutterstock

Over the last few months, the expectations regarding what the Fed will do this year have shifted considerably. At the end of last year, analysts and economists believed there would be five, six, or in some places, even seven small interest rate cuts this year and that, we were told, was what was pushing stocks to record highs.

So far this year though, with inflation proving stubborn, those expectations are now for only three rate cuts during the year on average, and yet the market is still flying, hitting new record highs on nineteen days over the last three months. And, if premarket futures are to be believed, another high is possible today as I write this.

Stock chart

Clearly, six cuts aren’t needed to support stocks, and now the question being asked is whether we even need three to keep things ticking along. Would it be better to leave things as they are, given that current interest rate levels haven’t done any real damage? In some ways, the number and size of rate cuts should only affect stocks in as much as they affect the economy. If the Fed gets it right and manages to tame inflation without significantly affecting economic activity and growth, then it doesn’t matter how many, or how few, cuts that takes.

The problem, though, is that in market terms, the relationship between stock prices and the level of interest rates is not just about their impact on economic activity. Traders and investors also have to consider the relative attractiveness of bonds and stocks as investments.

When bonds were yielding just a couple of percent per year, as has been the case for most of the post-pandemic era, putting money into the stock market was the only way that all investors, ranging from the large institutions to individuals, could get a decent return from U.S. assets. The added risk inherent in stocks seemed worth taking when the alternative was to make basically nothing on your money.

Now, though, with interest rates back to somewhere around their long-term averages, that calculation has changed somewhat. If there seems to be any real risk of an economic downturn over the next few months, the exit from stocks will be hastened by a move into bonds that would make sense for two reasons.

Not only would the yield be more attractive in that environment, but there would then be the prospect of rate cuts, which would push bond prices higher. Investors would be choosing between stocks, with heightened risk, and bonds that paid a decent yield and had the prospect of capital appreciation.

That is why many big equity investors have gone from pinning all their hopes on as many cuts as possible this year to whispering about one change or no cuts at all on the basis of “If it ain’t broke, don’t fix it.” At this point, that looks like sound advice. It seems that the productivity gains from the increasing use of AI are more than offsetting the effects of higher interest rates, without refueling inflation.

The jobs market is still strong, consumer confidence remains at reasonable levels, and the economy is still growing, so why change anything? That is especially true because of the message that rate cuts by the Fed would send to the market. There is a danger that it would be seen as a sign that the Fed, where some of the best economists and economic forecasters give their opinions, are worried about the future.

So, as crazy as it seems, the market sentiment may have shifted to where the risk is that if the Fed does cut, or cuts aggressively, that would prompt a selloff in stocks. Traders and investors views have shifted and while that should not really influence the Fed’s thinking, it does make a more conservative approach to inflation control less risky for Jay Powell and therefore increases the chance of just one rate cut this year, or maybe even none at all.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

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