All it took was one inflation report to ignite the stock market.
Just over a week ago, the Consumer Price Index (CPI) for June came out. The report showed that price levels fell by 0.1% in June compared to May.
That may not sound like much, but it was the first monthly decline in the CPI since May 2020.
And it was below the average economist estimate, which called for another increase.
It also brings inflation a hair closer to the Federal Reserve’s 2% target.
That set off a firestorm in the stock market. In fact, it led to some of the largest gains in history.
So today, let’s dig into the reason investors cheered the CPI report… and why the optimism may be a mistake…
Rate Cuts Incoming
We saw some noteworthy market action in the wake of the CPI report.
The Russell 2000 Index of small-cap stocks added 11% in only five days. Over that stretch, the Russell outperformed the S&P 500 more than it ever had before.
And both the Dow Jones and the S&P 500 rallied to new record highs in the days following the CPI’s release.
The reason comes down to interest rates.
Due to spiking inflation, the Fed started raising interest rates in March 2022.
It ultimately increased them to the highest level in 20 years, as you can see below.
The Federal Funds Effective Rate (2000-2024)
Source: Board of Governors of the Federal Reserve System; Federal Reserve Bank of St. Louis (FRED)
Higher interest rates slow the economy and bring inflation under control.
But now signs show easing inflation. So investors are betting that interest rate cuts will be on the way soon.
Lowering interest rates will reduce borrowing costs and help stimulate the economy. That’s why investors responded by pushing stocks higher.
But before you get too excited, you’d better study your history… and be careful what you wish for.
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Behind the Curve
It takes significant time for interest rate changes to impact the economy.
Most economists will tell you that we need to wait at least six months to feel the impact of higher or lower rates.
That means the Fed is almost always behind the curve.
By the time the Fed starts cutting interest rates, the damage is often already done to the economy.
Just look at a couple of prior episodes when the Fed began cutting rates.
In late 2000, the Fed started reducing interest rates just as the dot-com crash got underway.
The shaded areas on the chart below are periods of recession. You can see that the economy fell into recession three months after the Fed cut rates.
The Federal Funds Effective Rate (1999-2011)
Source: Board of Governors of the Federal Reserve System; Federal Reserve Bank of St. Louis (FRED)
And take a look at when the Fed cut interest rates in the middle of 2007, right before the Great Financial Crisis hit.
Four months later, the economy fell into recession.
In both instances, the S&P 500 plunged into a deep bear market… even as the Fed was cutting rates.
Now, there’s no guarantee we’ll see similar results this time.
Maybe this time the Fed will be on the ball and cut rates before it’s too late to avoid a recession. Or maybe this time is simply different.
But don’t think that rate cuts automatically translate to higher stock prices.
As history shows us, some of the worst bear markets in history have happened as the Fed reduces rates…
Happy trading,
Larry Benedict
Editor, Trading With Larry Benedict