Why Interest Rate Cuts Won't Automatically Boost The Stock Market

Interest rate cuts can significantly influence cash movement into money markets, but the popular belief that this maneuver automatically drives stock market gains is often overstated.

Earlier this month, JPMorgan strategists stated in a research note that the Federal Reserve’s anticipated rate cuts might not be sufficient to drive a new surge in the stock market.

"Fed will start easing, but more in a reactive way and as a response to weakening growth — this might not be enough to drive a next leg higher," they said.

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Many investors think cash will flood into stocks as money market yields decline, driving higher prices.

However, this cash-on-the-sidelines theory ignores a fundamental reality: every stock purchase has a seller on the other side, meaning no new money truly enters the market.

Stock trading is a two-way street and a business of shares and funds swapping hands between buyers and sellers. When one meets the other, money merely changes ownership.

Even in initial public offerings (IPOs), primary investors and the company sell shares to new buyers, transferring funds from one party to another. For secondary offerings, dilution occurs, where existing shareholders' stakes become less valuable as more shares are issued.

Despite this, the myth of sidelined cash persists, particularly in bullish periods. Portfolio Manager and CFA Charterholder Ben Carlson recently provided a historical perspective.

By observing historical data, he demonstrated that falling money market yields haven't led to a significant exodus of money from these funds in the past. While the $6.3 trillion sum in money market funds looks astronomical right now—it is double the pre-pandemic level—when money market yields previously fell, such as in 2005-2009, assets in these funds surged rather than fell.

Relationship between Money Market Funds and yields, Source: Bloomberg / Ritholtz Wealth Management

One reason for this is the purpose of money market funds. Much of the money in these funds isn't meant for stock investments but serves other purposes like emergency savings, corporate reserves, or funds allocated for short-term expenses. This money is parked in liquid assets that offer safety and liquidity, not growth. Even when interest rates drop, many investors prefer to keep their money in these funds rather than take on the volatility of stocks.

The relationship between interest rates and market behavior is complex. In periods of falling yields, investors may shift to other safe assets, like bonds, rather than chase stock market gains. Falling yields often signify a flight to safety, and equities are typically too risky assets to fit into that narrative.

But the bond market was annihilated in 2021 and 2022, marking some of the worst times for fixed-income investors. Rapidly rising interest rates pushed the 10-year yield to almost 5%—a level not seen since July 2007.

Given the current economic environment, marked by historically high price-to-earnings (P/E) ratios, a prolonged market consolidation seems possible even for a soft landing.

This scenario would allow earnings growth to become a more prominent driver of market re-pricing, as it reduces the inflated P/E ratios without requiring new cash to enter the system. Thus, despite the myths, it's not cash flow but the willingness to pay that drives stock prices up or down.

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