The Fed Is Expected to Cut Interest Rates. The Stock Market Usually Does This Next (Hint: It May Surprise You)

Key Points

• The Federal Reserve finishes a two-day meeting on Sept. 17, and policymakers are expected to cut interest rates by at least 25 basis points.

• The stock market has historically struggled in the aftermath of interest rate cuts, with the S&P 500 returning an average of 3% during the next year.

• Wall Street is more optimistic about where the stock market is headed; analysts expect the S&P 500 to advance nearly 11% in the next year.

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The Federal Open Market Committee, the policymaking body of the Federal Reserve, will make a decision concerning interest rates after the conclusion of a two-day meeting on Sept. 17. The Fed will release its policy statement and economic projections at 2:00 p.m. ET, and Fed Chair Jerome Powell will host a press conference at 2:30 p.m. ET.

Entering the meeting, the target range on the federal funds rate was 4.25% to 4.5%, but the market is certain policymakers will lower rates. Futures contracts put the probability of a 25-basis-point cut at 96%, while the probability of a 50-basis-point cut is 4%, according to CME Group's FedWatch tool.

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While investors often root for lower rates, the S&P 500 (SNPINDEX: ^GSPC) has historically delivered lackluster returns in the aftermath of rate cuts. Here are the important details.

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How the Federal Reserve sets monetary policy

The Federal Reserve is charged with maintaining stable prices and maximum employment. Its primary means of adjusting monetary policy is changing the target range for the federal funds rate, the interest rate banks charge each other to borrow money overnight. Changes in that benchmark ripple throughout the economy and impact the rates on credit cards, personal loans, and mortgages.

The Federal Open Market Committee (FOMC) is a 12-member group that meets eight times per year to review economic conditions and vote on monetary policy. Officials lower the target range for the federal funds rate when they want to stimulate the economy and boost employment, and they raise the target range when they want to slow the economy and curb inflation. The FOMC is currently in the middle of a cutting cycle that began in September 2024.

The stock market typically struggles after interest rate cuts

Federal Reserve policymakers have lowered the target federal funds rate 55 times since 1990. Investors are usually excited by the prospect of lower rates because consumers and businesses spend more money when the cost of borrowing drops, which theoretically leads to more robust economic growth and stronger corporate financial results. But hoping for rate cuts is somewhat paradoxical.

Interest rate cuts are essentially medicine for a slowing economy, so investors rooting for rate cuts are hoping the economy is sick enough to need medicine, but not so sick as to cause a recession. When policymakers make changes to the federal funds rate, it means they are concerned about one half of their dual mandate to maintain stable prices and maximum employment. In other words, either inflation is too high or employment is too low.

For instance, the market currently anticipates a rate cut of 25 basis points in September because recent labor market data shows businesses are hiring workers at the slowest pace in years, probably because of the uncertainty created by tariffs. The S&P 500 has actually moved higher since that jobs data was released because it's bad enough to warrant lower rates, but not yet so bad that an economic downturn is imminent.

Given the excitement rate cuts generate, investors may be surprised to learn that stocks often struggle in the aftermath. Since 1990, the S&P 500 has returned an average of 3% during the 12-month period after interest rate cuts. Comparatively, the index has added about 9% annually (excluding dividends) during the last 35 years, easily topping its post-rate cut returns.

Wall Street analysts anticipate stronger returns in the next year

Wall Street is more optimistic about where the stock market is headed. By aggregating the median target prices on every company in the S&P 500, FactSet Research builds what is known as a bottom-up forecast for the index. Currently, that forecast says the S&P 500 will hit 7,310 in the next year, which implies about 11% upside from its current level of 6,615.

At the sector level, Wall Street analysts anticipate the greatest upside in technology stocks as the artificial intelligence (AI) boom continues to unfold. The bottom-up forecast for the technology sector implies about 15% upside in the next year. Technology stocks also have the highest percentage of buy ratings (64%) in the S&P 500.

As a caveat, the S&P 500 currently trades at 22.5 times forward earnings, a premium to the five-year average of 19.9 times forward earnings. That is a very expensive valuation that has historically correlated with losses in the next year, so investors should only buy stocks they are prepared to hold through a downturn.

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Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends FactSet Research Systems. The Motley Fool recommends CME Group. The Motley Fool has a disclosure policy.