The Federal Reserve is leaving the key interest rate unchanged, but keeping open the possibility of a future increase
The Federal Reserve is leaving the key interest rate unchanged, but keeping open the possibility of a future increase
News this week that inflation fell more than expected in October reinforced the view that the Federal Reserve is finished with its most aggressive rate-hiking campaign in four decades.
And that could be a boon for the stock market and your 401(k).
According to an analysis by Ryan Detrick, chief market strategist at Carson Group, in the last 10 rate hike cycles since 1974, the S&P 500 index rose an average of 14.3% in the 12 months following the Fed’s final rate hike.
By comparison, the index’s average return through 2022 is 7.5% over five years, 10.4% over 10 years, 7.5% over 30 years and 10% over the last century, according to NerdWallet.
The message?
Investors really like it when the central bank no longer bombards them with interest rate increases.
What happens if the Fed raises interest rates?
Interest rate hikes drive up the cost of mortgages, auto loans, credit card purchases and other loans, dampening economic activity and hurting corporate profits, Detrick notes. They also make stocks a relatively less attractive investment than bonds, which carry less risk as yields now rise.
The pain, of course, ostensibly serves a good cause — fighting inflation, which could become entrenched and, at least according to the Fed, do even more damage.
Stopping interest rate increases has the opposite effect, brightens the economic outlook and makes stocks more attractive than bonds. It also removes a large cloud of uncertainty from the market, says Adam Turnquist, chief technical strategist at LPL Financial.
Is the stock market recovering?
From the day the Fed began raising interest rates in March 2022 until last Monday, the S&P 500 experienced some wild swings but eventually came to a halt at 4,411. But since the Labor Department released the upbeat consumer price index report early Tuesday, the benchmark stock index has risen more than 100 points, or 2.3%.
“If July was the last raise, which we believe was the case, stocks historically perform quite well a year after that last raise,” Detrick says.
LPL Financial’s Turnquist called it a “catalyst for the stock market.”
There are some caveats.
First, Fed officials have said they have not ruled out further rate hikes, even after the encouraging inflation report, although most economists have.
How does a pause in interest rates affect the market?
And although the end of rate hikes resulted in double-digit market gains in eight of the 10 rate hike cycles over the last half century, the S&P 500 suffered steep 12-month losses in two of those episodes. Stopping interest rate hikes in July 1981 failed to prevent a 16.4% market decline amid a brutal recession triggered by interest rates still at rock bottom below 17%.
Even the easing of tariff increases in June 2000 could not prevent the dot-com recession of 2001.
“The (dot-com) bubble had burst, which limited the impact of a pause and subsequent rate cuts,” Turnquist says.
At the other end of the spectrum, the Fed’s decision in 1995 to end large rate hikes and subsequent rate cuts may have helped produce a 35% market return in the year following the last rate hike. But also a robust economy that gained momentum through software-based productivity improvements.
In other words, in most of the Fed’s previous decisions to stay quiet, the agency has been a “key driver” of strong market gains, Turnquist says. But sometimes other forces were at play.
Such dynamics could impact stocks and your 401(k) account in the coming months.
What happens in an earnings recession?
For example, according to recent earnings reports, S&P 500 companies appear to have emerged from a year-long earnings recession (marked by declining quarterly earnings) in the third quarter. That could boost the market.
The same goes for a continuation of recent strong productivity gains, which would be further boosted by artificial intelligence and allow employers to increase wages without increasing prices, says Detrick.
Are stocks currently overpriced?
At the same time, stocks are relatively expensive at 18.6 times estimated earnings over the next 12 months, above the 10-year average of 17.6, according to Turnquist and FactSet. That puts more strain on the economy and profits to perform well, Turnquist says. If the US is hit by a moderate or severe recession, it can weigh on the market regardless of what the Fed does or doesn’t do.
Additionally, note that the solid market gains following the Fed’s decision to halt rate hikes may also have been reinforced by subsequent rate cuts. The Fed raised interest rates for the last time in December 2018, contributing to market gains of 11.7% and 17.7% over the following three and six months, respectively.
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But in August 2019, Fed officials began cutting interest rates, which helped push S&P yields to 27.9% in the 12 months after the last hike.
In the medium term, a Fed that stays on the sidelines could further boost stocks. However, according to futures markets, investors are expecting interest rate cuts by May or possibly even sooner.
If the Fed pushes back against that narrative and continues to push the “higher for longer” mantra, “stocks could pull back and give up some of that recovery,” Turnquist says.