US Federal Reserve Chairman Jerome Powell arrives for a press conference after the Monetary Policy Committee meeting on December 18, 2024.
AFP via Getty Images
The Federal Reserve implemented its third interest rate cut of 2024 yesterday, aiming to reduce borrowing costs throughout the economy. However, following the announcement, the Dow, S&P, and Nasdaq all experienced significant declines due to the Fed’s economic projection for 2025, which suggests only two rate cuts next year due to persistent inflation and other economic conditions.
Biotech stocks were particularly hard-hit by the news. For instance, while the S&P 500 and Nasdaq dropped 3% and 3.6% respectively, the closely monitored biotech indexes XBI and SPBIOS saw declines of nearly 5%. The Nasdaq biotechnology index also fell over 4.2%.
“Biotech stocks are typically sensitive to interest rate changes due to their continual funding requirements,” explained Niels Peetz-Larsen, a partner at asset management firm HighVista Strategies, to Forbes.
This development poses a challenge for biotech startups as well. The Fed’s efforts to combat inflation through rate hikes in 2022 and 2023 resulted in reduced investments in the sector. While rate cuts this year have led to a slight uptick in investment, these investments are currently driven more by fear of missing out than by genuine innovation, as noted by Sara Choi, a partner at Wing Ventures, to Forbes. “That’s why you see so many GLP-1 competitors in obesity management right now,” she remarked.
Choi believes that breaking out of this cycle will require more IPOs and mergers and acquisitions. These actions could bring wins for investors and increase liquidity, ultimately helping the biotech market stabilize and become less reactive, she added.
However, persistent high interest rates could hamper these efforts, making it more challenging for new breakthrough startups to thrive. “Increased borrowing costs make it more expensive for startups to fund research and development and sustain operations, thus slowing down innovation,” according to Pitchbook analyst Kazi Helal.
Higher-than-expected interest rates may have other repercussions, Helal pointed out. This scenario is likely to drive investors towards sectors with more predictable returns, making it harder for startups to secure funding. It could also dampen M&A activity by major pharmaceutical companies, “limiting exit opportunities for biotech startups and constraining the overall funding ecosystem,” he added. (Although this effect may be offset to some extent by the regulatory stance of the incoming Trump administration, which is anticipated to be more lenient on M&A.)
With fewer venture investments flowing into biotech, companies can explore “biobucks” deals as an alternative. These partnerships involve research collaborations with large pharmaceutical firms, typically entailing an initial payment and additional funding as key research and clinical milestones are achieved in developing a new drug.
In the context of higher-than-expected rates, Helal told Forbes, “I think the number of deals may decrease but the total deal value could remain stable or even increase.” Major pharmaceutical companies are likely to gravitate towards biobucks deals with late-stage companies that possess compelling clinical data rather than early-stage startups. Helal also noted that startups entering into these deals may face more favorable terms for the larger company.
This shift towards biobucks arrangements could also influence the types of startups that venture capitalists choose to invest in, Helal added, steering them away from drug-specific ventures and towards those innovating the drug discovery process itself. “They may also focus on advancing late-stage clinical companies towards successful exits,” he highlighted.
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While these are the risks in the current interest rate environment, there is no guarantee that the Federal Reserve will cut rates at all in 2025. Thus far, President-elect Trump has consistently advocated for tariffs. In a recent letter to Congress, the Congressional Budget Office stated that Trump’s proposed tariffs could “increase inflation” and “reduce returns on new investments.”
This combination might prompt the Federal Reserve to pause rate cuts or even raise interest rates again. A more stringent funding environment, as Helal mentioned, “can erode investor confidence and make securing funding particularly challenging for startups, especially those lacking late-stage assets.”
In an industry fueled by innovation, one of the major costs is missed opportunities. A market environment that diverts investment away from innovation and towards safer bets could delay disease treatments for patients for years, or potentially prevent them from reaching the market altogether.
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