The Fed may cut interest rates this week. History says stocks will continue to do so.

The long-awaited moment has arrived. The Federal Reserve meets this week, and economists expect policymakers to launch the first interest rate cut in four years. The Fed began raising rates from 2022 to calm raging inflation and has since raised the benchmark rate 11 times, leaving it at 5.5% today. This is the highest level in 20 years.

These moves worked, with inflation falling during this period. Right now, it’s at 2.5% and close to the Fed’s 2% target. Why this level? Because “it is most consistent with the Federal Reserve’s mandate for maximum employment and price stability,” according to the Federal Open Market Committee.

So economists and traders have speculated that the Fed will cut the benchmark rate by at least 25 basis points on Wednesday, with some even predicting a cut of 50 basis points. As a stock market investor, you may be wondering what the market will do following the Fed’s move. Let’s look to history for some clues.

Image source: Getty Images.

Why is a rate cut such a big deal for stocks?

First, let’s consider why a rate cut is such a big deal for the stock market in general and investors in particular. Higher rates can hurt corporate earnings and investor appetite for stocks due to several factors. As the mortgage rate rises, so do other borrowing costs for individuals and businesses.

For example, high-growth companies that rely on loans to build their businesses will see these expenses increase. As a result, potential investors may worry about their ability to fund growth and stay away from these types of stocks. As for individuals, higher borrowing costs affect their budgets and that means they probably won’t have as much discretionary income to spend.

Investors, seeing this, often lose confidence in the most vulnerable stocks in this type of environment. They may be hesitant to buy shares of those young growth companies — often technology players — and may stay away from companies, such as those in entertainment or travel, that rely on discretionary spending.

Investors could even control their investments in the stock market as a whole and opt for investments that tend to thrive in a higher rate environment, such as bonds.

Of course, as interest rates fall, the situation changes, with borrowing becoming easier and cheaper for businesses and individuals, while consumers find themselves with more money to spend on non-essential goods. All of this paints a brighter picture for corporate earnings and, in turn, makes investors more confident about putting their dollars into the stock market.

Performance of the S&P 500 after previous rate cuts

Now, as we wait for the Fed’s next move, let’s consider how the stock market has reacted to rate cuts in the past. In the last two cycles of cuts, since the initial rate cut, a S&P 500 index (^GSPC 0.13%) grew by double digits in the 12 months following that move. These rate cuts occurred on March 3, 2020 and August 1, 2019, and the S&P 500 rose 27% and 10%, respectively, in the following year.

Before that, rate cuts occurred during the Great Recession and a housing market crash in 2007 and 2008. The first rate cut then occurred in September 2007, and this time it took much longer for the S&P 500 to return to previous levels.

^ SPX data by YCharts.

It’s important to note, however, that the Great Recession was a particularly difficult time globally, so it’s not a good point of comparison for the S&P 500 today.

What does all this mean for the evolution of the stock market? It is impossible to predict what the index will do next, but recent history shows us a favorable trend. That said, if the Fed cuts rates as expected or cuts even more aggressively this week, it won’t ease the borrowing situation for businesses and individuals overnight. It will take a series of cuts to produce concrete results.

But the good news is that a potential rate cut this week will get things moving in the right direction — and that could help the S&P 500 buck its recent historical trend and move higher into the year ahead.