The Fed lowered interest rates again recently, but signaled it may hold off on further rate cuts going forward. That could cause markets to stall.

On October 30, the Federal Reserve’s Open Market Committee voted to cut short-term interest rates for the third time this year. At the same time, officials indicated they may not cut rates any further in 2019 as the economy seems to be stabilizing and the job market is healthy.

Markets took this news in stride, continuing to ignore the recession in manufacturing and flagging corporate earnings growth. The S&P 500 is up 24% this year and closed Nov. 1 at an all-time high as investors pin their hopes for more stock market gains on a strong U.S. consumer and easing trade tensions. 

I think the recent Fed decision matters. Below are three reasons investors should pay attention to the likely pause in rate cuts:

  • Treasury futures markets have priced in additional rate cuts, indicating that investors expect more than one additional cut through next year. If the Fed doesn’t reduce interest rates further, the yield curve, an important economic indicator based on government bond market prices, could flatten. That, in turn, could make some stock investors rethink positions they took based on expectations for more rate cuts and faster economic growth ahead.

  • Stock valuations could be too high. One reason stocks have risen this year is that equities are often valued based on their ability to earn more than the benchmark Treasury yield. If rates don’t fall as low as investors have anticipated, stocks may need to be repriced. Earnings growth is now slightly negative year over year and positive earnings gains rely on economic growth, which may not materialize. At the recent all-time high, S&P 500 stocks were priced at 18.5 times forward earnings, a historically high level. I expect markets to remain directionless for at least the next couple of months.

  • The dollar may be stuck in a range against a basket of foreign currencies. Prospects for additional rate cuts have contributed to a weaker dollar, a positive for U.S. exporters, commodity prices and the many emerging market nations that issue dollar-denominated debt. With the Fed pause, the dollar is likely to stay in the current range.

Range Bound Markets

It’s not just the dollar. I expect U.S. stock and bond markets to remain directionless for at least the next couple of months, now that the Fed monetary policy lever is apparently halted for now. Investors must rely on economic and earnings improvements to drive further gains. Until those improvements materialize, actively-managed funds, not index funds, are likely to be the stronger performers.