How do stocks perform after the Fed cuts interest rates? Pretty well, actually

The stock market has had a nice run in 2024, but investors have been nervous lately, because many are concerned that a slowing economy may tip over into an outright recession. To thwart that possibility, the Federal Reserve stands poised to lower interest rates, providing stimulus to consumers and businesses, some of whom have been reeling despite overall economic growth.

Will lower interest rates be enough to put a floor under the economy and turn things around, or is the Fed's first interest rate cut the signal for the bottom to fall out of the market? The question plagues many investors, but recent research suggests that they should be optimistic.

Stocks higher after the Fed cuts interest rates

Investors can be pardoned if they're concerned about the state of the economy as the Fed is about to begin lowering interest rates after one of the fastest rate increase campaigns in history, which spanned from 2022 to 2023. The Fed often begins cutting rates when the economy clearly weakens, and so lower rates are often a sign that the economy is well on its way to a recession.

At the same time, lower rates are a positive for companies and stock valuations. Rate-sensitive companies such as small banks, real estate investment trusts (REITs) and heavy borrowers can benefit substantially from lower rates. They also help stock prices, with investors discounting future earnings at lower rates, boosting the present value of those future cash flows today.

While these things are notable positives, investors have to get from here to there first. That is, monetary policy has a noted lag effect, often measured as six months. The Fed's actions today aren't really felt for a while, and during that time a slipping economy can continue to weaken, requiring even lower interest rates and more Fed action to resuscitate it. As the economy slides, corporate profits may fall significantly — and with them, investor sentiment and stock prices.

But research from Hartford Funds suggests that investors should remain optimistic. Its work indicates that U.S. stocks are higher — 11%, after factoring in inflation — one year after the Fed begins slashing rates. That's plenty of reason for investors to hold steady on stocks.

The Hartford team reviewed 22 occasions from 1929 to 2019 when the Fed first cut rates and how stocks, bonds and cash performed over the subsequent 12 months. The after-inflation return of stocks averaged 11%, but returns diverged when the cut was associated with a recession.

When the rate cut occurred and no recession took place, stocks averaged returns of 17% in the following year. But even when a recession took place, stocks were still 8% higher.

"All else being equal, lower interest rates are favorable to stocks for two reasons: They make safe haven investments like cash and fixed income less attractive as interest rates fall, and they make it easier for companies to borrow, expand and grow — the type of actions that boost corporate earnings and drive stock prices," says Greg McBride, CFA, Bankrate chief financial analyst.

Of particular note for investors today, returns for stocks following the June 1995 cut and the September 1998 cut hit 23% and 25% in the following year, respectively. Like today, the mid1990s was characterized by modest slowdowns amid a generally robust economy.

The after-inflation returns for other asset classes were less attractive, according to Hartford:

—Government bonds were 5% higher a year later.

—Corporate bonds were 6% higher a year later.

—Cash was a modest 2% higher after a year.

Naturally, some periods saw stocks underperform the average, but of the 22 periods that Hartford reviewed, just six of them saw negative after-inflation losses.