The Fed’s September Rate Cut Sparks a Shift in the Market

The Federal Reserve Bank (Fed) cut the overnight rate by 0.50% (50 basis points) on September 18, 2024. The cut was much anticipated after Fed officials indicated a cut was likely, given inflation declined and was approaching their target of 2.0%. The Fed held rates steady at the prior nine meetings after hiking aggressively from 0.25% on January 26, 2022, to 5.50% by July 25, 2023. The rapid hiking campaign was in response to inflation rising to the highest level since the early 1980s. Current expectations include several more cuts in the upcoming meetings with the overnight rate dropping to 3.5% by the end of 2025.

The Fed has a dual mandate of full employment and price stability (modest inflation). To help meet this mandate, the Fed typically uses interest rates and its balance sheet. If inflation rises to a level deemed too high, the Fed will typically raise the overnight rate to increase borrowing costs and cool consumption. In addition, the Fed can sell bonds to help push up interest rates, an exercise known as quantitative tightening.

The rate cut in September marked the start of a shift away from concerns around inflation to a focus on employment and boosting economic growth. The labor market is starting to show some signs of weakness as it moderates in response to higher interest rates. The impact of higher rates tends to take time to impact the economy, and the Fed does not want to wait until the labor market is weakening significantly before they begin cutting rates. The Fed was arguably late to begin easing in 2000 and during the great financial crisis of 2008, which likely contributed to recessions in both cases.

Thus far the financial markets have responded favorably to the Fed’s rate cut. The cut was projected several months ago and interest-rate-sensitive areas of the market have moved higher. Historically, the more interest-rate-sensitive areas of the economy, such as the utilities, real estate, and industrial sectors perform well in low interest rate environments. In the quarter, these sectors within the S&P 500 were up 19.4%, 17.2%, and 11.6%, respectively, with the S&P 500 increasing 5.9%. Small cap US companies also tend to perform well when interest rates are falling. The Russell 2000 small cap index jumped 9.3% in the quarter, after a slow start in the first half of the year.

Dating back to the start of rate hikes in 2022 and continuing through the first half of 2024, investors had a strong preference for the largest US growth companies and those projected to benefit the most from the adoption of artificial intelligence. The prospect of cuts and the Fed’s announced cut on September 18, 2024, has led to a shift in leadership within equities and a strong recovery in bonds in the third quarter. Value stocks have assumed leadership over growth stocks and small cap stocks are outperforming large cap stocks. International markets have awoken from a long slumber and are posting strong returns in part due to the US dollar depreciating in response to lower interest rates. Although this rotation away from large cap growth stocks is only a quarter old, assuming the Fed keeps moving interest rates lower, it is reasonable to believe the winners in the third quarter will carry this momentum forward into 2025. During prior rate cutting campaigns where the US economy avoided recession, equity returns were above average in the 12 months following the first cut and the more interest rate sensitive sectors and bonds also performed well.