Title: Wall Street Predicts Multiple Interest Rate Cuts by the Fed in 2025 - Understanding the Impact on Stocks
The U.S. Federal Reserve fought against escalating inflation throughout 2022 and 2023, ultimately boosting the federal funds rate (overnight interest rates) dramatically. This move caused interest rates, including the 30-year fixed mortgage rate, to spike, hitting a 20-year high of 7.8% by the year's end.
High interest rates can restrict economic growth. However, inflation, as reported by the Consumer Price Index (CPI), is now slipping back towards the Fed's annual goal of 2%, so they've initiated a reversal of their tightening strategy. The central bank reduced the federal funds rate in September and November, and analysts speculate additional reductions might occur during their next meeting on December 17 and 18. Wall Street also expects the Fed to cut rates twice in 2025.
So, what does this mean for the benchmark S&P 500 stock market index in the upcoming year?
Why Interest Rates Are Decreasing
The COVID-19 pandemic spurred a mixture of inflationary pressures. The U.S. government disbursed trillions of dollars in stimulus money to boost the economy, while the Fed lowered the federal funds rate to a historically low range of 0% to 0.25%. Concurrently, factories worldwide shuttered to halt virus spread, resulting in shortages and price hikes for various goods, such as televisions and cars.
Inflation, as indicated by the CPI, began edging up in 2021, but soared to a 40-year high of 8% in 2022—well beyond the Fed's 2% target. As mentioned earlier, the central bank launched an aggressive campaign to increase rates, taking the federal funds rate to a range of 5.25% to 5.50%. This marked a significant departure from its near-zero historical levels.
Pandemic-related supply chain issues were mostly resolved in 2023, and higher interest rates played a role in helping the annual increase in the CPI decrease to 4.1%. By October 2024, the most recent reading, the CPI fell to an annualized rate of 2.6%, close to the Fed's target.
Because of this, the central bank felt confident enough to slash the federal funds rate by 50 basis points in September, followed by another 25 basis points in November. According to Bloomberg data, Wall Street anticipates two rate cuts in 2025 (each representing 25 basis points). The CME Group's FedWatch tool aligns with this prediction.
Is a Recession Imminent?
Despite high interest rates, the U.S. economy demonstrated remarkable resilience in 2024. GDP increased at a periodical rate of 2.8%, exceeding the 10-year average of around 2%. However, signs of weakness are emerging. The unemployment rate, which began the year at 3.7%, has risen to 4.1%. Further deterioration in the employment market may lead to reduced consumer spending.
Interestingly, a rate-raising cycle by the Fed typically precedes recessions. Graphing the federal funds rate with recessionary periods shows a consistent correlation (gray-shaded regions).
Interest rate policy takes time to influence the economy, so the negative effects of rate increases in 2022 and 2023 may not have fully manifested yet. Timing rate cuts is challenging when aiming to avoid a recession but not missing its onset.
While there's no indication of an imminent recession, investors should monitor the employment market closely in 2025, as it may signal warning signs of trouble ahead.
Lower Interest Rates Foster Stock Market Growth, but be Aware of Short-term Volatility
Lower interest rates generally benefit the economy by reducing debt service costs and increasing borrowing power, prompting increased spending on larger-ticket items like homes and vehicles. This boosts corporate earnings and, consequently, stock prices. New investors flock to stocks, due to reduced returns on risk-free assets like cash and government Treasury bonds.
However, there are extenuating factors to consider. For instance, the S&P 500 has nearly doubled annual returns of 20% twice since 1957, reaching an index valuation above historical norms. As of writing, the index trades at a pricing-to-earnings (P/E) ratio of 25.1, marking a 38% premium compared to its long-term average of 18.1.
The incoming Trump administration's trade policies may introduce tariffs that could hamper a stock market rally. The President-elect has already threatened tariffs on key trading partners like Canada and Mexico, potentially derailing market momentum.
Even if falling interest rates persist, their positive impact on stocks in 2025 might not be as pronounced as in previous periods of rate reductions. Be cautious of volatility in the short term, but keep in mind that long-term investors should view any correction as an opportunity for future growth.
Lower interest rate cuts could potentially stimulate stock market growth in 2025, as reduced debt service costs and increased borrowing power may lead to increased spending and corporate earnings. However, investors should be mindful of the stock market's current valuation, which is trading at a premium compared to its historical average, and potential volatility may arise in the short term.
Given the historical correlation between the federal funds rate and recessions, while there's no imminent indication of a recession, investors should keep a close eye on the employment market in 2025, as it might provide warning signs of trouble ahead. In terms of finance and investing, lower interest rates could incentivize individuals and businesses to take on more debt for investment purposes or to purchase assets, potentially boosting economic growth.
