If you're curious about how ASX shares might react when interest rate cuts start rolling in, history offers some valuable insights.
As a reminder, interest rates are tremendously important to all things finance and investment. They determine the cost of credit, essential for borrowing. They also determine yields on various fixed-income instruments. Finally, they are crucial in the valuation of stocks
It's unsurprising, therefore, to see the impact of changing interest rates on the market, both to the upside and downside. Such has been the case over the past three years.
Let's explore what typically happens to the S&P/ASX 200 Index (ASX: XJO) once interest rates begin to drop.
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How do interest rate cuts impact ASX shares?
Interest rate cuts often send ripples through global markets, and the ASX is no exception. Here, we'll be talking about rates set by the US Federal Reserve, which ripple through the global economy like a stone dropped in the water on a still night.
When the Fed lowers rates, it can lead to increased global liquidity – more money supply – which usually bodes well for equity markets like the ASX.
But historically, the performance of ASX shares after the first Fed rate cut has been a mixed bag.
According to ASX price data obtained from CommSec and interest rate data from the US Federal Reserve, the ASX 200 gained about 7% over the six months following the Fed's rate cut in July 1995. Conversely, after the July 1990 cut, the index fell by 23% in the same period.
The median return for the ASX 200 index is about 6–7% in the next year after the first Fed rate cut.
Notably, many of these cutting cycles saw rates lowered several times over the 12 months.
- Average 12-month return: 1.10%
- Median 12-month return: 6.50%
- Best 12-month return: 13.15% (after the September 1998 rate cut)
- Worst 12-month return: -24.26% (following the September 2007 rate cut)
What kind of cut? It depends
History tells us there are two primary factors that can help dictate where markets might track next. It really depends on what caused the decision to cut interest rates in the first place.
The first is economic growth. When the Fed cuts rates to address growth concerns rather than to combat a recession, ASX shares have often performed well.
For example, after the September 1998 rate cut, which was aimed at stabilising markets amid Asian financial crises, the ASX 200 climbed nearly 16% over the next half-year.
The second is recessionary signals. On the flip side, if interest rate cuts signal looming economic weakness or a recession, the ASX tends to struggle. Following the cut in January 2001, during the dot-com bust in the US, the index only gained 4% over the next year.
As you can see, it all depends on what we're dealing with in economic reality.
If rates are cut to kindle economic growth, creating a boost for productivity, investors turn bullish and we rally.
The peaches are in season, as they say.
But if the cuts are brought on because the Fed wants to avoid a recession? Not too optimistic.
This is an important consideration. There's a hot debate on whether we're heading into a recession or not. Right now, we need more economic data to prove it either way.
Foolish takeaway
While past performance doesn't guarantee future results, history indicates that the context of interest rate cuts plays a significant role in how ASX shares perform afterwards.
It all depends on the reason for the cut.
From here, we shall have to wait and see what the economy does alongside the ASX.
