Last month, Federal Reserve Chairman Jerome Powell made it unmistakably clear that the Fed is likely to cut rates at its September meeting. “The time has come for policy to adjust,” Powell said, making it clear he believed rates should come down. The Federal Open Market Committee’s (FOMC) next formal meeting will conclude September 18.
It was nearly four and a half years ago, in March of 2020, when the Fed last cut rates, taking its target interest rate to nearly 0% during the early days of the pandemic. It’s now been nearly two and a half years, since March of 2022, that the Fed began raising rates to try to combat the highest inflation in decades.
It’s been some time since investors have experienced declining interest rates. It is therefore worth considering the investment implications of potential reductions in interest rates.
How fast and how far will the Fed go?
Magnitude and timing are two very different things. This is especially true with respect to any potential rate cuts. Though the Fed has communicated the high likelihood that rate cuts are coming, we still don’t know how quickly they may (or may not) bring rates down — or by how much. Chairman Powell’s announcement doesn’t mean the Fed is ready to take rates from 5.25% — their current target rate — back to zero. In fact, given current economic data, it’s arguably very unlikely that we’ll see rates return to their pandemic-era lows.
The truth is that the Fed itself will likely wait to see how the economy responds before it decides to sustain, cease, or, dare I say, even reverse any prospective rate cuts. As Jerome Powell said at the Fed’s annual symposium in Jackson Hole, Wyoming, though “the direction of travel is clear” the “timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
In the past 20 years, there have been two major cycles of rate cuts — the round of rate cuts heading into the global financial crisis in 2008, and the round of rate cuts that started in 2019 and ended with rates at zero during the pandemic. It’s worth keeping in mind that during both of those episodes, the Federal Reserve faced major economic crises, soaring unemployment, and plunging inflation, making the decision to cut rates during those crises an easy one.
Today, the economic data in favor of a rate cut is anemic at best. Though it has drifted upward, the unemployment rate is still fairly low. Inflation has come down but remains stubbornly higher than the Fed would prefer. There are currently no economic alarm bells screaming for lower rates.
What are the investment implications of lower rates?
Though the speed and depth of rate cuts is uncertain, a few general observations can be made about the typical impact of rate cuts on markets.
Lower rates typically bode well for longer-term risk assets, like stocks and longer-term bonds. Lower interest expense for companies with debt, for example, results in higher earnings for those companies. This is precisely why we’ve witnessed significant outperformance in small cap and value stocks since early July.
However, we should remember that markets are quick to price in such information. The fact that the Fed is all but certain to cut rates in September is already priced into markets. Just last month, an abrupt spell-off spooked many investors. (See Putting the Current Market Sell-Off in Context.) Already, the overall market has made a nearly complete recovery from that brief sell off, as investors anticipated the Fed would move to cut rates.
Should the Fed cut rates deeper or more quickly than expected, some companies will likely benefit more than others. As previously written, lower interest rates are likely to disproportionately benefit the outlook for small cap companies. About one-third of the companies in the Russell 2000 have floating rate debt, and around 40% of these companies are presently unprofitable — which could change thanks in no small part due to lower interest expense on their debt.
What about real estate?
Whenever talk turns to interest rates, it’s natural to wonder the impact on real estate. Typically, interest rate cuts, especially as and when they lead to lower mortgage rates, are a boon for the housing market.
But there are no laws of physics in finance, and thus no guarantee that rate cuts this time will have the same impact as before. One reason for caution in the present climate is that the sharply higher interest rates of the past two and a half years failed to result in any meaningful correction in residential real estate. It’s possible, perhaps likely, that residential real estate prices have long priced in expected lower future mortgage rates—essentially looking past the higher rates since 2022. We should be humble and resist assuming that lower interest rates will automatically lead to higher home prices.
With respect to commercial real estate, much of the sector remains deeply underwater and far beyond the ability of a minor 25 or 50 basis point rate cut to revive a sector of the economy that has been slammed by shifting demographics and work from home trends.
Key takeaways
Remain patient. We don’t know how far or how fast the Fed will cut rates. All we know is that the Fed is changing the course of monetary policy. We should resist any temptation to try to time markets in moments like this. Rather than attempt to time markets, it’s best to remain patient and fully invested.
Remain diversified. Any time the Fed makes a change to monetary policy, it is difficult to identify simple cause and effect relationships. It is very difficult to determine how exactly a change in monetary policy is going to impact markets and the economy. We should reject soundbite economics that attempt to draw such simplistic connections. Over time, the best strategy is to remain invested in a portfolio that’s properly diversified across public and private assets, and across and within major global asset classes.
Most of us are both borrowers and investors. Not all of us, but many of us, are both borrowers and investors. Now may be a good time for many families to meet with their advisors to reevaluate their balance sheets — both their assets and liabilities — to explore the potential impact (or opportunities) that lower interest rates may create for their financial position.
Your advisor can help determine how best to position your portfolio as rate cuts approach, in addition to answering your questions about the Federal Reserve. Not a Mercer Advisors client but interested in more information? Let’s talk.
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