Interest rate policy can be complex and so is its potential impact on the market, but the investment strategy is simple.
You might have heard that the Federal Reserve is considering a cut in interest rates when the Federal Open Market Committee meets later this month. Such an action invariably leads some investors to ask what that means for the stock market, specifically AI stocks that have produced remarkable returns for most of the past two years.
As crucial as interest rate policy is to the markets and the U.S. economy, nobody can say for sure what will happen, or how some decisions could affect stocks. The issue can be quite complex.
Here is what to look for and how investors can best prepare for whatever might happen over the coming weeks.
Image source: Getty Images.
About Fed rate cuts
The Federal Reserve’s primary job is to keep the U.S. economy on the road to steady growth. An economy growing too quickly can create inflation high enough to hurt consumers (although a little inflation is actually a good thing). A slow or contracting economy (recession) is also bad because it can mean asset prices fall and people lose their jobs.
The Federal Reserve’s primary tool to steer the economy in the right direction is the federal funds rate, the primary interest rate banks use when lending to each other. The rate banks charge has ripple effects that trickle through the rest of the economy in numerous ways.
The Fed dropped the rate to a range of zero to 0.25% at the start of the pandemic to keep the economy moving even as many parts of it were effectively locked down. The low rates over an extended period eventually overheated the economy and led to outsized inflation that had its own (mostly bad) effects. The Federal Reserve then hiked rates starting in 2022 to get that outsized inflation back under control:
Target federal funds rate lower limit; data by YCharts.
Last month, Federal Reserve Chairman Jerome Powell made some public comments that signaled the real potential for a rate cut as inflation fell to under 3% and some concerning employment indicators signaled that the economy is showing signs that it may be slowing too much.
Why AI stocks could rally on lower rates
As to how these adjustments in Fed rate policy might affect AI stocks, some analysts argue it could spark a bit of a rally. Many of these AI companies are investing heavily in the technology, and lower interest rates make it cheaper for them to borrow needed capital to fund their efforts. All other things being equal, investors tend to like companies with less debt on their books. So a rate cut tends to be a good thing for younger capital-intensive companies.
However, investors shouldn’t want rates too low; The near-zero-percent rates in 2020 and 2021 made for lots of borrowing that helped inflate a widespread market bubble, driving stock prices for technology companies and other speculative assets to elevated levels. When interest rates inevitably rose, those companies lost their easy money and investors got worried about the levels of spending going on. That helped burst the bubble in late 2021 and early 2022. Many of those companies have yet to return to the stock price levels they hit during that time.
If done well, easing into lower rates can be enough to ease up financing costs and help support growing companies that then generate steadily higher stock valuations. A good rate change policy can create sustainable growth for technology and AI companies over the coming years. If the Fed can pull off this “soft landing,” it will have managed to lower rates enough to cool inflation without causing a recession. That’s no easy task.
Why stocks could fall instead
Other analysts worry that rate cuts could spark a market crash. Rate cuts imply that there is something wrong with the broader economy (even if there isn’t) and investors can overreact to the Fed’s actions which can cause others to overreact, and suddenly everyone is selling off to avoid being the last one still in the market. The message that a rate cut sends really matters to many.
The Federal Funds rate now hovers between 5.25% and 5.50%. According to the analysis of futures contracts, the market gives 70% odds that the Fed will reduce that range by 25 basis points to between 5% and 5.25%. There is a 30% chance for a cut of 50 basis points to between 4.75% and 5%.
Why might a steeper cut be problematic? It could give the market the sense that the Federal Reserve is panicking, which would likely only happen if policymakers fear a recession. A recession would signal that the Fed waited too long to cut rates and that the economy is already contracting or is about to.
This scenario is referred to as a hard landing, i.e. a recession. As mentioned above, recessions mean negative growth and higher unemployment, hurting corporate earnings and stock prices.
How investors should handle the situation
Either scenario could happen and has happened in the past. There have also been cases where something in between the two scenarios occurred. There are many moving parts, so nobody can say what specifically will happen.
For investors, it’s better to focus on what they can control: Their investment strategy.
For those interested in AI stocks, they need to remember that this technology is going to affect the world over the coming decade and beyond. Estimates peg the economic impact of AI on the economy in the trillions of dollars. Whether the market goes up or down over the next year based on movements of the Fed Funds rate probably won’t matter much a decade from now.
Long-term investors should focus instead on identifying the best AI stocks to own for the long term. Buy shares slowly and steadily over time using a dollar-cost averaging strategy. That way, you can celebrate if stocks rise and buy more at lower prices if they go down. What the interest rate is at the time shouldn’t be the driving force in any investment decision that might be made.
