What impact will the Federal Reserve's rate cut have on stocks?

U.S. stocks leaped to record highs Wednesday before fading after the Federal Reserve delivered an interest rate cut on the larger side of expectations, reducing its benchmark rate by 0.50 percentage points.

Trading remained quiet until the Fed's announcement at 2 p.m. Eastern time, but surged as investors assessed the central bank's aggressive move to ease borrowing costs for consumers and businesses. The Dow Jones Industrial Average jumped 375 points to a new record before slipping and ended with a 103 point loss at 41,503, down 0.3%.

"We really need to see how the market reacts tomorrow — it takes time to digest all of that," said Ryan Sweet, chief U.S. economist at Oxford Economics. "The markets were crossing their fingers for a larger cut."

The decision by the Fed's policy-setting committee to cut interest rates for the first time since March 2020 was prefaced by an unusual amount of market uncertainty as to how much the central bank would lower its benchmark rate from a two-decade high of 5.25% to 5.5%, where it has stood since July 2023. 

Art Hogan, chief market strategist at B. Riley Wealth Management, said the Fed's messaging is more important than the exact size of its cut, as policymakers embark on what is likely to be a series of reductions through this year and next. 

"Whether it's a quarter or half a point, it's much more about where they are going and when are they going to stop," Hogan told CBS MoneyWatch. 

Beyond the short-term impacts, the Fed's move is largely seen as positive for the stock market and for the broader economy, with rate cuts less stress-inducing for equities when they come during non-recessionary periods.

"Market environments with declining rates and rising profits tend to be supportive of equity prices," according to John Lynch, chief investment officer for Comerica Wealth Management. "A few cuts are welcome, more cuts would be troublesome," Lynch said. 

Jobs, not inflation, are again the key economic gauge

Instead of parsing government reports on inflation to gauge future monetary moves by the Fed, Wall Street will now fixate on weekly jobless claims and other data related to the labor market, Hogan and others said. 

"We anticipate that these Fed cuts should have a positive effect on the economy and markets in 2025. We believe the global economy is likely to benefit as well, as major central banks around the world have already cut rates or are on the verge of doing so," Scott Wren, senior global market strategist at Wells Fargo, said in a note.

Expectations of Fed rate cuts have had investors shifting gears and gravitating toward public companies that are interest-rate sensitive, including dividend stocks, telecoms, consumer staples, utilities and real estate investment trusts, Hogan offered. 

Public companies with smaller market capitalization are likely to draw more interest in an environment with falling interest rates and steady economic growth, according to Hogan, who pointed out that the segment is well-priced, given its relative underperformance.

"You've got the ingredients for a rally in small caps," said Hogan.

Bringing down interest rates should drive some much-needed inventory out of existing home sales and fuel economic activity. 

Reductions in short-term interest rates should be a boon for dividend-paying stocks, particularly in the financial sector, as lower rates reduce the cost of funding for banks. Other beneficiaries include public companies that would benefit from cheaper debt financing and lower interest rates. 

Real estate stocks are also likely to benefit as lower rates reduce borrowing costs for buyers. 

The Fed's rate cut and messaging is directing Wall Street's concerns toward jobs and away from higher costs. "We are less concerned about inflation and more concerned about a soft landing in the labor market," said Hogan.