Here’s how stocks react to Fed interest rate cuts | Official Website of Louis Velazquez, entrepreneur, finance guy and tech innovator

Those investors who were hoping that the Federal Reserve’s decision to lower interest rates by 1% until the end of 2024 would mean more stock market-friendly cuts in 2025 have been gravely disappointed.

Despite reducing interest rates last September, November, and December, Fed Chair Powell has refrained from additional cuts this year, worried they’ll fuel inflation even as inflationary tariffs kick in.

The latest inflation data suggests he’s not wrong to be concerned about the direction of prices.

CPI Inflation year-over-year since April:

July: 2.7%
June: 2.7%
May: 2.4%
April: 2.3%

Source: Bureau of Labor Statistics.

However, jobs data is equally worrisome, and the Fed’s mandate is to balance inflation and unemployment, not pick favorites.

Unemployment rate by month in 2025:

July: 4.2%
June: 4.1%
May: 4.2%
April: 4.2%
March: 4.2%
February: 4.1%
January: 4%

Source: Bureau of Labor Statistics.

With unemployment at 4.2% and at risk of rising to new highs, most expect the Fed to (finally) lower interest rates when it meets again on September 17, and many expect more cuts in 2026.

For example, Morgan Stanley predicts two cuts in 2025 and quarterly rate cuts throughout 2026, bringing the Fed Funds Rate to a range of 2.75% to 3%, down from 4.25% to 4.5% currently.

If they’re right, it could have a big impact on what’s next for stocks.

The stock market historically performs best when the Federal Reserve is cutting interest rates.

Image source&colon; TheStreet/Shutterstock

Federal Reserve rate cuts are bullish for stocks

There are no guarantees when it comes to investing, but history does tend to rhyme. If that’s true, it may mean that the stock market reacts positively to a Fed rate cut in September, particularly if Powell signals it’s not a one-and-done style reduction.

According to Morgan Stanley’s data crunching, stock market returns are much better during rate-cutting regimes than when the Fed is neutral or increasing rates.

Historically, the S&P 500 has returned an average of 1.7% per month during Fed interest rate cutting periods, substantially better than the negative 0.5% monthly loss when rates rise.

According to Morgan Stanley, when the Fed is stuck in neutral, like now, the S&P 500 returns 1.3% on average per month:

“The S&P 500 typically delivers strong performance during Fed cutting regimes… The index’s valuation tends to remain supported when the policy rate is being reduced and earnings growth is above the long-term median — which is what they expect to sustain over the next 12 months.”

Why rate cuts support stock prices

Fed interest rate cuts don’t directly control lending rates set by banks, but they do indirectly impact them.

The Fed sets rate policy by adjusting the Fed Funds Rate, which is the rate banks charge each other on overnight loans of bank reserves. When the Fed makes borrowing more expensive overnight, banks raise rates to maintain their net interest margin. The opposite is true when it cuts rates.

As a result, lower rates tend to mean lower borrowing costs- good news for corporate and household spending and bullish for corporate revenue and profit growth- the lifeblood of stock market returns.

Stock market valuation is high, but earnings growth is too

Given the stock market’s current backdrop, the potential for lower rates to support valuation when earnings are growing faster than usual is particularly interesting.

The S&P 500’s forward price to earnings ratio (P/E) is higher than usual, following the benchmark index’s 30% rally from its low in early April.

More Economic Analysis:

According to FactSet, the forward one-year P/E, which is based on consensus earnings estimates, is 22.4—above the 19.9 and 18.5 5-year and 10-year averages.

In the past, P/E ratios this high haven’t been a great sign for returns one year later. However, Morgan Stanley’s research suggests that stocks can continue to boast high valuations during rate-cutting periods as long as their earnings grow faster than normal.

According to FactSet, that appears to be the case this year.

In the second quarter, the S&P 500 delivered earnings growth of 11.9%. In Q3, Wall Street expects momentum to slow, but it will still clock in up 7.5% from one year ago.

Since June 30, Wall Street’s estimates for S&P 500 companies’ aggregate 2025 earnings have increased by 1.6% to $268.48, with communication services, financials, and consumer discretionary sectors all seeing increases above 3%.

Overall, S&P 500 earnings are expected to rise 10.6% and 13.4% in 2025 and 2026.

Over the past ten years, S&P 500 earnings growth has averaged 9.2% and since 1990, average annual earnings growth has been 10.32%, according to Multpl based on S&P Global data.

“Liberation Day (April 2) marked the trough of the rolling recession,” concludes Morgan Stanley.

Key takeaways:

Stocks gain an average of 1.7% per month when rates are falling
They lose 0.5% per month when rates rise
Rate cuts can support stock valuations during periods of above-average earnings growth.
S&P 500 earnings are expected to climb 10.6% in 2025, above the 10.32% average.