How Could Interest Rate Cuts Impact Stocks?

by | May 1, 2024 | Research

Interest rates have dominated investing conversations over the past two years as the Fed raised rates significantly then held them at an elevated level. Now, the economy is showing signs of strength, and the focus has flipped to the possibility of rate cuts.

Lower interest rates are likely to be a boon for individuals making large purchases on credit and may also provide a boost to their stock portfolios. There are a few key reasons that lower borrowing costs are typically beneficial for stocks, starting with their impact on business growth.

Lower Interest Rates Spur Business Expansion and Stock Growth

Businesses tend to borrow more money when lower interest rates make it cheaper to do so. The projects they typically finance with this debt are expansionary – such as buying new buildings, upgrading technology, or hiring additional staff to launch a new product.

The purpose of expansionary projects funded with debt is typically to increase profitability – either by reducing costs or improving revenue. When businesses can afford to undertake these projects, they tend to result in higher profits and, consequently, higher stock prices.

In addition to lower rates on new loans, businesses with existing variable rate loans owe smaller interest payments once rates fall. These lower expenses lead to higher profitability and stock prices – all other factors remaining constant.

Interest Rate Cuts Boost Consumer Demand and Stock Prices

Like businesses, individuals tend to borrow more money when interest rates fall. This trend benefits businesses that sell expensive items that typically require financing – like homes, cars, and appliances. Lower interest rates increase demand for these products and increase revenue for businesses that sell them. With higher revenue comes higher profits and stock prices.

Companies that sell large-ticket items are not the only ones that benefit from higher consumer demand, however. When individuals owe less in interest, they have more room in their budget for discretionary purchases. For this reason, many different types of businesses tend to indirectly benefit from lower interest rates and the impact they have on consumer demand.

A Lower Risk-Free Rate Is a Boon for Growth Stock Valuations

Growth stocks are those that are expected to increase in value rather than paying high dividends. Because these companies tend to pay little or no income, they can’t be valued using traditional methods. Instead, investors determine a fair price using a formula that relies on the risk-free rate.

The risk-free rate is the theoretical rate of return that an investor would expect to earn on an investment with zero risk. Since no such investment exists, the closest substitute is the 3-month Treasury bill rate. This rate is highly sensitive to changes in overall interest rates and tends to fall quickly when the Fed cuts rates. For this reason, Fed rate cuts tend to boost growth stock valuations almost immediately.

Lower Bond Yields Make Stocks a More Attractive Investment

Bond yields are highly attuned to the Fed Funds Rate and tend to fall quickly when the Fed cuts interest rates. Lower bond yields make those investments less attractive and encourage investors to purchase stocks instead – driving stock prices higher through competition.

Less desirable bond yields coupled with higher profitability for businesses and higher growth stock valuations tend to create an environment conducive to rapid stock growth. In fact, early projections for stocks in 2024 were overwhelmingly positive due in part to projected interest rate cuts. Now that expectations for interest rate cuts have been delayed to the fourth quarter or even early next year, these projections are a moving target.

To prepare for lower interest rates, reach out to an experienced financial advisor to discuss how these changes could impact your portfolio. An advisor who specializes in stock trading can help you locate companies likely to benefit from lower interest rates and shift your portfolio to take advantage of their potential growth.

DreamWork Financial Group Can Help You Forecast How Rate Cuts Impact Your Portfolio

While it is important to understand how interest rate changes impact the stock market as a whole, it is more important to understand how they can impact your investments. DreamWork Financial Group can review your portfolio, help you understand how it could be affected by rate cuts, and suggest changes to help you make the most of lower rates.

Our innovative wealth management program, Investing Gameplan™, includes a custom portfolio overseen by a fiduciary financial advisor who can adjust your investments to match the current market. Best of all, there is no minimum investment to participate.

Contact us today to get started.

Article Topics: Interest Rates | Stocks