What would happen to the markets if interest rates stayed where they are?

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The Bank of Canada has further interest rate announcements planned for April and June, but the chances of further rate cuts are not good.Chris Wattie/Reuters

This should be the year of rate cuts. The only question was how quickly and by how much central banks would cut interest rates to the delight of investors and borrowers everywhere.

Well, you can forget about a rate cut in March – it almost certainly won't happen. The chances are also not good for April or June, when the Bank of Canada plans to make further interest rate announcements.

The Federal Reserve, meanwhile, is likely to be in a holding pattern until at least July, forced to make only three or four interest rate cuts this year, according to overnight index swaps that serve as an indicator of interest rate expectations.

A few months ago, markets expected up to eight Fed rate cuts this year, which would result in a two full percentage point cut in the federal funds rate.

Financial markets seem to finally be coming to the conclusion that there is no urgency at all for central banks to cut interest rates. With market probabilities for rate cuts falling so quickly, the question becomes: What if there were no rate cuts at all this year?

This question has far-reaching implications for stock markets, which have rallied sharply on the belief that the hour to cut interest rates was near.

Global financial markets experienced a turning point last October as belief in a soft landing grew. Inflation suddenly subsided without the economy succumbing to the forces of recession.

Since then, the S&P 500 Index has risen 23 percent in just four months. The Nasdaq Composite Index is up 27 percent, while the S&P/TSX Composite Index is up 13 percent.

Why the Canadian stock market is an idiot on a global scale

The good sentiment has spread to stocks worldwide, all based on the idea that the battle against inflation has been won and a rate cut is on the way.

“These expected rate cuts have been a big part of this rally,” said Stephen Lingard, head of investment research at CI Investments’ multi-asset team. “It helped the market overcome earnings weakness.”

The rise in stock prices was largely due to rising market metrics rather than rising corporate profits. In other words, improving investor sentiment outweighed the pressure on company fundamentals.

So what happens if you ignore interest rate cuts? They remove a key stimulus at a time when stock markets could be particularly vulnerable to swings in sentiment.

You'll be hard-pressed to find a credible forecast that says this year will be without rate cuts.

But it can hardly be seen as a distant scenario when economic data has largely contradicted consensus over the last year or so.

Just look at the state of the US economy, which was almost universally expected to slide into recession last year. Not only did this not happen, U.S. GDP growth accelerated to 2.5 percent last year from 1.9 percent in 2022.

“If that remains the case, how can the Fed cut interest rates if inflation remains problematic?” Mr Lingard said.

The higher-for-longer mantra that investors largely abandoned last year has crept back into mainstream economic commentary.

However, the stock market itself still has to adjust to the possibility of minimal interest rate cuts this year. That would almost certainly put a damper on investor sentiment, which currently seems to be driven by the euphoria of artificial intelligence.

The Canadian stock market is particularly vulnerable to high interest rates due to its heavy weighting in value stocks and dividend-paying names. For example, most dividend-focused Canadian ETFs have posted negative returns in the two years since the Bank of Canada began raising interest rates.

This is a big reason why the TSX has been a significant laggard during this period of high inflation and higher interest rates. But therein lies the silver lining. Canadian stock prices are so deeply discounted that they are likely less vulnerable to a decline in interest rate hike optimism.

Canadian stocks have a valuation multiple of about 15 times next year's earnings, compared to 22 for the U.S. market.

For the TSX, there is strength in weakness.