Key takeaways
Equity investors appear to be most focused on factors such as the economy and corporate earnings, with interest rates having less influence on the broader market.
In late 2024, however, certain equity market sectors were negatively impacted as long-term bond yields rose.
Interest rate projections for 2025 are clouded by scaled back expectations for further Federal Reserve rate cuts.
In 2024’s closing months, a mixed interest rate environment appeared to have limited consequences for the broader stock market. The period was marked by the Federal Reserve (Fed) cutting the federal funds target rate (a rate used by banks with each other for overnight lending), by 1% between September and December. While Fed rate cuts are generally encouraging to equity investors, longer-term bond yields, such as the 10-year U.S. Treasury note, moved higher during that period, creating headwinds for some interest rate-sensitive equity market sectors.
Consequently, fourth quarter equity market performance leveled off, yet the S&P 500 still managed to end the year up about 25%. Equity investors generally appeared less focused on interest rate trends and more attentive to other factors.
“Today’s interest rate environment is less influential for stock investors today than the favorable state of corporate earnings and economic growth,” says Rob Haworth, senior investment strategy director for U.S. Bank Asset Management. “The fact that long-term rates remain elevated is having some impact within certain interest-rate sensitive sectors of the market.”
“Today’s interest rate environment is less influential for stock investors today than the state of corporate earnings and the economy,” says Rob Haworth, senior investment strategy director for U.S. Bank Asset Management.
Haworth notes that even at today’s elevated levels, 10-year Treasury yields don’t yet pose a significant concern for the broader equity market. “To this point, the 10-year Treasury yield remains below the 5% threshold,” notes Haworth. “If yields reach 5%, it will indicate some frustration among bond investors with government deficits, and that could bleed over to have negative equity market implications.” Although markets exhibited year-end volatility, stocks in 2024, as measured by the benchmark S&P 500, moved higher.
Fed interest rate moves are often seen as a signal to bond investors, and beginning in 2022, yields on bonds across the board rose as the Fed raised the fed funds target rate from near 0% to a peak of 5.50%. In October 2023, 10-year Treasury yields topped out near 5%. From late April to mid-September 2024, the 10-year Treasury yield trended lower, dropping to 3.63%. But once the Fed began cutting short-term interest rates, the 10-year Treasury yield moved nearly 1% higher than its September 2024 low.1
“In 2023, as interest rates appeared to be approaching peak levels for this cycle, markets shifted.” As a result, after underperforming small-cap stocks in 2022, large-cap growth stocks far outpaced small stocks in 2023 and in 2024’s first half. In mid-2024, as interest rates fell, smaller stocks started to outperform large-cap growth stocks.2 This chart compares performance of large-cap growth stocks (S&P 500 Growth) and small-cap stocks (Russell 2000 Index).
At its December 2024 meeting, the Fed lowered expectations for 2025 fed funds target rate cuts. While its initial projections called for another 1% of rate cuts by the end of 2025, its December forecast reduced planned cuts to 0.50%.2 “A less accommodative Fed raises some equity market concerns,” says Haworth. “It’s an indication that corporate borrowing costs won’t go down as quickly as expected, which could have implications for corporate earnings.”
“Higher rates are more of a problem for smaller companies that typically have shorter-duration borrowings and require more frequent refinancing,” says Haworth. “Other interest rate sensitive sectors like utilities and real estate are also losing ground given the trend of higher Treasury bond yields.” When Fed rate cuts were on the horizon in the third quarter, small-cap, utilities and real estate stocks performed well. However, the subsequent trend of higher long-term bond yields detracted from fourth quarter performance.3
Interest rates remain an important consideration for equity investors. “The Fed isn’t headed back to the pre-2022 ‘zero interest rate’ environment,” says Haworth. “Inflation may be settling in at a higher level, in the 2.5% to 3.0% range. If that’s the case, the Fed is likely to set its current fed funds rate cuts somewhere close to 3.0%.” Given present interest rate trends, Haworth believes equities in general remain well positioned, driven primarily by strong economic fundamentals and solid corporate earnings growth.
As you assess your own circumstances, be prepared for potential stock price fluctuations in the near term. Stocks should continue to represent a key component of any long-term investor’s diversified portfolio. “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 the stock market up, inflation retreating and interest rates in flux, 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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