Key takeaways
Solid consumer spending and strong corporate earnings continue to bolster stock prices even as higher interest rates persist.
Although the Fed has delayed planned interest rate cuts, certain equity market segments continue to thrive.
While higher interest rates can at times create challenges for equity markets, stocks continue to make gains. Investors appear to have confidence in stocks owed to strong consumer spending that’s helping bolster corporate earnings. Elevated inflation and interest rates, while still concerning, are lesser factors.
“Consumer spending and business capital expenditures remain strong, and that’s a reason for bullishness about stocks in the near term,” says Eric Freedman, chief investment officer for U.S. Bank Wealth Management.
U.S. stocks, as measured by the benchmark S&P 500, started the year on a positive note, with a 10% first quarter gain. After suffering an April setback, the S&P 500 has since rallied to new all-time highs.1
“There’s less interest rate pressure on stocks now because the Federal Reserve has held the line on interest rates,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “The market adapted to current interest rates, and is prepared for the next direction in rates to be lower.” After dropping to a bear market low point in late 2022, at the same time interest rates began rising significantly, stocks have rallied since.
The stock market’s sharp downward trend began after the Fed initiated a series of increases in the short-term federal funds target rate it controls. That resulted in the fed funds target rate moving from near 0% to a range of 5.25% to 5.50%. However, the Fed has held rates steady since July 2023, and signaled its intentions to start cutting rates in 2024. While markets initially anticipated Fed rate cuts to begin in early 2024, the Fed has held off, and recently indicated that only one rate cut is likely this year.2
How are interest rates likely to impact the stock market going forward?
The Fed plays a role in managing key components of the U.S. economy, including moderate inflation, full employment and a modest level of long-term interest rates. In May 2024, inflation over the previous 12 months stood at 3.3%, much lower than its mid-2022 peak of 9.1%, but not yet down to the Fed’s 2% target.3 Fed officials are concerned that inflation has not managed to yet dip below 3%; it has stayed in a range slightly above 3% since mid-2023.
Haworth says it’s helpful to distinguish between rates the Fed controls and longer-term bond rates, such as the 10-year Treasury note yield. Yields on 10-year Treasuries rose from 4.20% in late March to 4.70% in late April, but have trended lower since. That was an encouraging sign for equity markets.
Today’s interest rate environment can mean different things to different kinds of companies. “When interest rates first moved higher in 2022, it took its largest toll on stocks with already high valuations,” says Haworth. That included growth-oriented technology stocks that prospered in a low interest rate environment. “In 2023, as interest rates appeared to be approaching peak levels for this cycle, the impact shifted,” says Haworth. “Higher rates have a greater impact on companies that need to borrow money to finance expansion.” Those tend to be smaller companies that don’t have large cash reserves. “For many smaller companies, the cost of funding at higher interest rates is a bigger concern than it is for larger companies, which have more cash on hand and often issue longer-term debt,” says Haworth. Markets appeared to recognize this fact. As a result, after underperforming small-cap stocks in 2022, large-cap growth stocks far outpaced small stocks in 2023 and started 2024 in an even stronger position. This chart compares performance of large-cap growth stocks (S&P 500 Growth) and small-cap stocks (Russell 2000 Index).
Stock market leadership, previously concentrated in technology stocks, broadened out earlier in the year, but in recent weeks, the trend reversed course. “The same, mostly technology-oriented stocks that dominated the market’s 2023 rally are once again driving the most recent market surge,” says Haworth. “There’s still a lot of room for the market's strength to broaden out to more sectors.”
While interest rate trends influence the stock market, performance is also closely tied to the strength of the U.S. economy. “As the Fed raises interest rates, we typically expect slower economic growth,” says Eric Freedman, chief investment officer for U.S. Bank Wealth Management. Surprisingly, however, U.S. gross domestic product (GDP) grew more quickly in 2023 (2.5%) than it did in 2022 (1.9%). Growth slowed modestly to 1.3% in 2024’s first quarter,4 but appears on track to expand throughout 2024, according to Freedman. “Consumer spending and business capital expenditures remain strong, and that’s a reason for bullishness about stocks in the near term,” he says. Freedman notes that businesses appear committed to getting “bigger, stronger and faster through technology spending.” That’s provided a solid boost to technology-oriented stocks.
Yet, interest rates are still a consideration for equity investors. Stock prices tended to track with bond yield trends over the course of 2023. When interest rates rose, stock prices retreated, and when rates fell, stocks reacted favorably. Haworth still anticipates a continuation of the kind of market volatility that’s existed since mid-2023. “The market is waiting for Fed rate cuts,” says Haworth, “but with the sense that the Fed won’t need to push rates higher, markets seem to be less fixated on the timing of those cuts.”
After its June 11-12, 2024, meeting, Fed Chair Jerome Powell indicated that rate cuts are still on the Fed’s radar, but the timing of such cuts remains a question.5 “The Fed is very focused on achieving its long-term inflation target of 2% (still below the current rate of 3.5%),” says Freedman.
While market interest rates may fluctuate in the near term, with some ramifications for stocks, it isn’t the only factor equity investors should consider. “Interest rates are likely to begin falling as inflation softens,” says Haworth. “A key factor is whether inflation declines because the economy stalls, or if it is a matter of prices softening within the context of a still-growing economy.” Haworth says the latter scenario is more beneficial for equities.
As you assess your own circumstances, be prepared for potential stock price fluctuations in the near term. Nevertheless, assuming that current inflation trends endure and the economy can hold its ground, stocks should continue to represent a key component of any diversified portfolio for long-term investors. “In part, this is due to the fact that equity returns can help investors keep pace with inflation,” says Haworth.
Talk with your wealth professional about your comfort level with your portfolio’s current mix of investments and discuss whether any changes are appropriate in response to an evolving capital market environment consistent with your goals, risk appetite and time horizon.
Note: The Standard & Poor’s 500 Index (S&P 500) consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. The S&P 500 is an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index and is representative of the U.S. small capitalization securities market. The Russell 2000 is an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results.
Interest rates can affect stock markets in different ways. Frequently, when rates rise, equities are challenged because investors can choose to invest in bonds that pay more attractive yields than was previously the case, rather than stocks. Higher rates can put pressure on stock valuations, as corporations may need to generate more attractive earnings to capture investor interest. Another way the interest rate environment affects stocks has to do with companies’ bottom lines. If a debt-issuing company faces higher borrowing costs due to rising rates, it may result in reduced company profits, which can be reflected in lower stock prices. These factors are among the reasons why equity investors pay close attention to the interest rate environment.
If the Federal Reserve raises the short-term federal funds target rate it controls (as it did in 2022 and 2023), it can have a detrimental effect on stocks. A higher interest rate environment can present challenges for the economy, which may slow business activity. This could potentially result in lower revenues and earnings for a corporation, which could be reflected in a lower stock price.
There is not a direct correlation on the direction of interest rates stemming from stock market movement. The state of the economy and inflation are bigger factors that help determine the direction of interest rates. In many circumstances, interest rate movements can affect stock prices. The biggest impact stock prices have on interest rates is on the demand for bonds. If stock prices decline, it may indicate investors are seeking to reduce portfolio risk and putting more money to work in bonds. This reflects an increase in demand for bonds, which typically allows issuers to offer debt at lower interest rates.
With inflation retreating and interest rate cuts likely coming later this year, how should investors position their portfolios to capitalize on potential opportunities, while guarding against risks?
A fresh look at managing your cash and investments in today’s changing interest rate environment can help support your pursuit of the goals that matter most to you.
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