The U.S. Federal Reserve made a big splash, announcing an oversized interest rate cut; a move that is expected to have a big impact on U.S. and Canadian financial markets. Over the last 14 months, the Fed held its key lending rate at a two-decade high of between 5.25% and 5.50%. But with inflation winding down to its target range, the Fed took the opportunity to cut the federal funds rate by 50 basis points, or 0.50%, to a range of 4.75% to 5.0%.
The federal funds rate determines the interest charged in overnight transactions between banks. In turn, traditional banks set their interest rates based on the Fed’s key overnight lending rate. And lower federal fund rates have an immediate impact on the stock market, borrowing, bonds, mortgages, credit cards, and car loans.
A bigger-than-expected interest rate cut means that inflation is under control and the economy is headed for a soft landing. Analysts expect the Fed to lower interest rates by another half percentage point by the end of 2024 and a full percentage point by the end of 2025. That would take the overnight lending rate down to a range of 3.25% to 3.50%. Further interest rate cuts in 2026 are projected to bring the federal funds rate down to a range of 2.75% to 3.0%%.
How Do Lower Interest Rates Affect the Stock Market?
While interest rate cuts have a major impact on all facets of the economy, lower interest rates are a boon for the stock market. Not only do lower interest rates make it cheaper to borrow and service debt, which is good for earnings, but investors pull their money from lower-yielding government bonds and money market funds looking for better returns on the stock market. Since 1929, the S&P 500 has gained 86% of the time in the 12 months following the first cut in the economic cycle.
So far, history is repeating itself. On September 19, the day after the Fed announced its big 50-basis point rate cut, the S&P 500, Dow Jones Industrial Average, and TSX all surged to new records.
The S&P 500 hit an intra-day high of 5,725.16 with the Dow hitting a record 42,105.01, putting the indexes up 20% and 11.6% respectively. The TSX meanwhile jumped to a record high of 23,909.53, putting the index up 13.5% year-to-date and 17.75% on an annual basis.
Why the big move on the TSX? The aggressive interest rate cut by the Fed helps protect the U.S. from slipping into a recession, which is a bonus for the Canadian economy. The U.S. is Canada’s largest trading partner. Lower interest rates also help support the Canadian dollar and give the Bank of Canada more wriggle room to cut its interest rates without the move negatively impacting the Canadian dollar.
The Bank of Canada makes its next interest rate announcement on October 23, 2024, while the Federal Reserve makes its next announcement on December 18, 2024.
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