What happens to the stock market when interest rates drop? Historical data provides some insight.

January 30, 2024
James Stevens

The Federal Open Market Committee (FOMC) is expected to cut interest rates multiple times in 2024. Given the conventional wisdom that the Fed funds rate affects stock market performance, many may wonder how such cuts might affect their investments.

To determine how the stock market has reacted in the past to rate cuts, I gathered and analyzed historical market and interest rate data going back to 1955. As you might expect, the results indicate that, on average, the market performs significantly better when interest rates are decreasing.

The following chart illustrates the phenomenon. You may be able to observe it in a few spots on the chart, and with a bit of mathematical analysis, we can quantify these observations.

Monthly interest rate and S&P 500 data since 1955. Blue: Annualized, cumulative trailing-6-month Fed funds rate (T6MFR). Green, red, grey: Future-12-month S&P 500 return when T6MFR is decreasing (green), increasing (red), or flat (grey).

I’ll provide additional mathy details below, but the high-level takeaway is that, on average, the S&P 500 gained 10.40% over 12-month periods that follow a declining Fed funds rate, compared to 5.98% when interest rates had increased. That’s a big difference, and keep in mind that these averages include periods following small, incremental interest rate changes, which we are likely to see multiple times this year, and which may continue on an ongoing basis until the Fed decides to stop cutting rates.

The difference between a 5.98% return and 10.40% return is substantial, especially if compounded over a longer time period. The fact that these averages represent almost 70 years of data, and that this period includes many distinct instances of increasing and decreasing interest rates, gives me some confidence that this result is meaningful. At the same time, as you can see in the chart, the S&P returns over 12-month periods have varied wildly, including several sub-20% losses, as well as many super-30% gains. Most years are not “average,” and countless (unpredictable) factors affect market movements. We’ll just have to see how “average” this period of decreasing interest rates is.

Finally, here are the answers to the questions that the mathematician and scientist readers have been muttering at their screens up to this point: S&P data set was not adjusted for inflation. For each month, I calculated a “current” Fed funds rate as the annualized, cumulative rate over the preceding 6 months. I considered this rate “increasing” or “decreasing” if it changed over those 6 months by more than +/- 0.1 percentage points, and “flat” if it changed by less. If I adjust either of these 6-month periods to 3 months, the resulting averages are similar. If I adjust the 0.1% delta to 0.2%, the resulting averages are similar. I used the arithmetic mean to compute these averages; if you’d like to see averages computed using the geometric mean, check out my spreadsheet.

Please send me a message if you have any feedback, or even, heaven forbid, find a bug in the spreadsheet!