On September 18, 2024, the Federal Open Market Committee (FOMC) lowered its benchmark interest rate by 50 basis points, or 0.50%. The move made headlines because it was the first interest rate adjustment since July 2023 and the first interest rate cut since March 2020.
The reduction was prompted by improving economic conditions in the US. Inflation, which had driven the Fed’s rate hikes in 2022 and 2023, fell below 3% in July 2024 and fell again in August and September 2024. With inflation approaching the Fed’s long-term rate of 2%, investors largely expect a series of interest rate cuts from now until mid-2025.
The big question investors are asking is how these lower interest rates could impact their portfolios and investment strategies. Let’s take a closer look at how the stock market typically reacts to falling interest rates.
When the Fed cuts rates, banks lower the rates they charge on loans to their customers. For existing debt with a variable interest rate, the reductions are effective immediately. In this case, business and private borrowers quickly benefit from lower current interest charges. New fixed-rate loans will also become cheaper, but existing fixed-rate loans will not be affected. However, rate cuts by the Fed could create opportunities to refinance fixed-rate loans at lower interest rates.
In short: interest rate cuts lower the cost of borrowing. Cheaper debt is generally good for business, but the reason for the rate cut affects the reaction of business leaders and investors.
Read more: What the Fed’s interest rate decision means for bank accounts, CDs, loans and credit cards
If the Fed cuts rates because inflation is slowing, the reaction should be positive. Companies are likely to pursue growth more aggressively. Investors expecting higher profits can channel more capital into the stock market. This can push stock prices higher.
Lower interest rates can negatively impact the stock market if they are prompted by an economic slowdown. When the economic outlook is uncertain, business leaders and investors may be more cautious about investing in growth.
According to Robert R. Johnson, CEO and chairman of active index strategy developer Economic Index Associates, “Stocks historically perform substantially better when the Fed cuts rates than when the Fed raises rates.”
More information: What is the Federal Reserve?
Investors’ expectations have a major influence on stock prices. For this reason, the effects of an interest rate change typically begin well before the Fed takes action.
When investors expect an interest rate cut and the economic outlook is good, stock prices rise. Once the Fed makes the cut, the aftereffects could be minimal. The exception to this is if the rate cut is more or less aggressive than investors expected. In that case, the market could shift again as investors adapt to new circumstances.
More information: Your step-by-step guide to investing
Johnson, who has extensively studied how Fed policies affect stock market returns, identifies the best-performing sectors when rates fall: auto, apparel and retail.
Johnson also sees opportunity in real estate investment trusts, or REITs, especially mortgage REITs. “With interest rates expected to continue falling in 2024 and beyond, both equity REITs and mortgage REITs could be attractive investments,” Johnson said.
More information: How to invest in real estate: 7 ways to get started
David Russell, global head of market strategy at trading platform Tradestation, expects lower rates will benefit cruise ship operators and airlines. “They are economically sensitive and have significant debt burdens,” Russell said. “Lower inflation will help their profitability, while lower interest rates can lower their borrowing costs.”
In summary, lower interest rates are extremely good for real estate values and for businesses that rely heavily on debt or discretionary consumer spending.
Investors routinely adjust their investments and trading behavior based on their economic prospects. This is evident in the market movements that follow reports on inflation, employment and gross domestic product.
More information: Jobs, Inflation, and the Fed: How They’re All Related
For example, the S&P 500 suffered a one-day decline of 3% in early August 2024 after a disappointing July jobs report sparked recession concerns.
Market shifts driven by trends in investor sentiment may have many wondering what steps to take ahead of Fed rate action. The right answer depends on the investor’s timeline and strategy.
More information: When is the next Fed meeting?
Investors who need to maximize income or growth within a relatively short time frame may see the opportunity to adjust their positions to the interest rate environment.
Typically, this involves shifting exposure between stocks and bonds. Bonds are preferred when interest rates rise, while stocks become popular when interest rates fall.
On the other hand, long-term investors with high-quality, diversified portfolios may want to avoid big changes in response to interest rate adjustments. Revising a portfolio based on temporary conditions can easily undermine results over time.
Lane Martinsen, founder and CEO of Martinsen Wealth Management LLC, describes the dangers of making short-term decisions over long-term portfolios.
“Responding to rate changes can lead to emotional decision-making, which can harm long-term performance,” Martinsen said. “Regular buying and selling to time the market often results in higher costs, taxes and missed growth opportunities.”
Long-term investors might instead rely on changing economic conditions to prompt periodic reviews of their portfolio composition or asset allocation. If the allocation functions and the risk profile is acceptable, few or no adjustments are required.
Still, a proven allocation strategy can allow for small changes to improve performance as interest rates change. In this scenario, Johnson recommends adjusting sector exposure.
Particularly as interest rates are expected to decline over time, investors could reduce their positions in the financial and utilities sectors while increasing their exposure to automotive, apparel and retail – sectors that have historically proven strong in declining interest rate environments.
Investors can make sector-based adjustments without changing their relative exposure to broader asset classes, such as stocks, bonds and alternative assets. This should keep the portfolio’s risk and appreciation potential relatively stable, which is critical for long-term growth.
If economic conditions continue to improve, we can expect serial rate cuts over the next six to eight months. As a result, frequent traders may want to invest more heavily in stocks than in bonds. Long-term investors can benefit from smaller sector adjustments that do not conflict with their existing, proven allocation strategies.
