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The reason the Federal Reserve is cutting rates is just as important as the action itself.
In a long-anticipated move, the Federal Reserve this week initiated a cut to the federal funds rate. While the magnitude of the cut came as a slight surprise — analysts expected a smaller 25-basis-point cut compared to the 50-basis-point cut that was announced — it is still believed to be the first of several additional cuts it will likely vote for over the next few years.
The 50-basis-point interest rate cut takes the federal funds rate, which is the target rate at which banks lend to one another overnight, to a range of 4.75% to 5%. Federal Open Market Officials anticipate the federal funds rate will move to a range of 4.25% to 4.5% by year-end and to a range of 2.75% to 3% by the end of 2026. In other words, the clear indication is that interest rates are going to drift lower over the next few years.
Against that backdrop, many investors may wonder: How will the current cut (and future cuts) affect the S&P 500 and exchange-traded funds (ETFs) that track the index, such as the Vanguard 500 ETF (FLIGHT -0.33%)?
How will a Fed easing cycle impact my S&P 500 ETF?
The answer to that question is: It depends. And what that depends on is largely why the Fed began cutting rates in the first place. According to research from Carson Group, two situations tend to see stocks perform strongly following a Fed rate cut, and one situation sees them perform poorly.
Stocks perform poorly following a Fed rate cut if the cuts were made during a recession. During both the 1990 and 2020 recessions, the S&P dropped more than 18% in the three months following the first Fed rate cut. And during three recent recessions (1990, 2007-09, and 2020), after six months, the S&P was down between 5% and 15% following the first rate cut. On average during recessions, the S&P was 12% lower one year after the Fed started cutting rates.
On the other hand, if the Fed begins cutting rates as a way to normalize policy, stocks tend to perform well. During the last three normalized rate-cutting periods, the S&P has been up between 5% to 15% a year after the first Fed rate cut.
The biggest gains, however, tend to come after the Fed begins cutting rates following a stock market panic. Following the first Fed rate cut in March 2020 due to the COVID pandemic, the S&P 500 was up over 27% in the next 12 months. Meanwhile, following the rate cut after the Sept. 11, 2001, market crash, the S&P was nearly 21% higher a year later.
Interestingly, one month after the Fed cuts rates, stocks often trade slightly negative after normalization and panic-induced cuts and slightly positive after recession-induced rate cuts.
Image source: Getty Images.
Is it time to buy the Vanguard S&P 500 ETF?
At this point, we can clearly see that the Fed was not cutting rates due to panic. So now the debate is whether the Fed is cutting rates as a return to normalization or as a way to stave off a recession.
For its part, in its commentary, Fed officials said that it continues to see the economy expanding at a solid pace while noting unemployment remains low. However, it did note that job growth has slowed and it lifted its unemployment expectations from 4% to 4.4%.
As such, at this point, it appears that this rate-cutting cycle is largely about a return to more normal policy after the Fed hiked rates to help bring down inflation. If that is the case, history says the S&P should be a solid performer over the next year.
Meanwhile, there was a record of nearly $6 trillion sitting in U.S. money markets to begin this year. As the interest rates on these investments begin to fall, some of this money could start to flow into stocks, helping lift the market and the Vanguard S&P 500 ETF.
Regardless, though, investors should not materially change their long-term investment strategy based on Fed actions. This particular Vanguard ETF has been a strong, consistent performer over the years, generating an average annual return of nearly 13% over the past decade.
It can be a core holding in anyone’s portfolio and is a great instrument to dollar-cost average into over time. This is a solid proven strategy that will also help take advantage of any market dips, which will inevitably occur. So for long-term investors, now is a great time to start investing in the Vanguard S&P 500 ETF.