Here is the breakdown of how interest rate cuts affect the stock market:
1. The Core Logic (Why stocks usually go up)
- Lower Borrowing Costs: Companies can borrow money more cheaply to expand their business. This reduces interest expenses and boosts bottom-line net profits.
- Valuation Lift: In finance, we use the Discounted Cash Flow (DCF) model. When the interest rate (the discount rate) decreases, the “present value” of future earnings increases, leading to higher stock valuations.
- Liquidity Injection: As savings accounts and bonds offer lower returns, investors move their “lazy money” into riskier assets like stocks to seek higher yields.
2. Winners and Losers by Sector
| Sector | Impact | Reason |
|---|---|---|
| Tech & Growth | High Positive | These companies rely on future growth. Lower rates make their distant future earnings more valuable today. |
| Real Estate | Positive | Lower mortgage rates stimulate buying activity and reduce debt service costs for developers. |
| Dividend Stocks | Positive | Stable stocks (like Utilities) become more attractive to “yield hunters” when bond rates drop. |
| Banking | Mixed/Negative | Banks often suffer from “compressed net interest margins”—the gap between what they pay depositors and what they charge for loans narrows. |
3. The “Catch”: Why stocks don’t always rise
The “Why” is just as important as the “How much”:
- Preventative vs. Emergency Cuts: If the central bank cuts rates to keep a healthy economy humming (“soft landing”), stocks soar. If they cut because the economy is crashing (“recession”), the fear of poor earnings might outweigh the benefit of lower rates.
- Priced In: If the market expected a 0.5% cut but only got 0.25%, stocks might actually fall because the news was already “priced in” and the reality was disappointing.
4. Global Context: The “Fed” Effect
When the U.S. Federal Reserve cuts rates, it often triggers a global ripple effect:
- Weaker Dollar: Capital tends to flow out of the US and into Emerging Markets (like China, SE Asia, or Latin America) in search of higher returns.
- Global Policy Room: Other central banks gain more “breathing room” to cut their own rates without worrying about their currency devaluing too quickly against the dollar.
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