How to Prepare for Potential Federal Reserve Interest Rate Cuts
After a historical rate hike cycle that was the fastest in history and largest in decades, the Federal Reserve has signaled it will begin rate cuts at its September 17-18 meeting.
Falling rates mean a potentially new investment environment that brings new opportunities for investors. It’s crucial for investors to review their asset allocations and have investment strategies in place to align portfolios for times ahead.
Prepare to navigate the shifting landscape with insights into Fed policy and rates, how the expected cuts can impact the economy and markets, and how to best position your portfolio.
Current Events
With this initial expected cut, the current rate plateau will have lasted just under 14 months, compared to the average pause of 7-9 months. This cutting cycle should also be longer and consist of small cuts over an extended period; the Fed’s current projections show a course from 5.25%-5.5% down to a target near 2.5-3%.
Historically, the Fed has raised rates in small increments to avoid market disruptions. These disruptions have endured too long resulting in proportionally larger cuts to respond to and provide stability during market events, economic storms, or geopolitical shocks.
This time, the Fed is doing the opposite. With inflation risks at a three-decade high, the Fed increased rates at the highest velocity in over four decades. Now the Fed is lowering rates in a measured manner in an effort to maintain a healthy, growing economy and jobs market without fueling additional inflation, referred to as a soft landing.
What This Means for the Economy
How the anticipated rate cuts impact the economy largely depends on two factors:
- Why is the Fed cutting rates
- How does the economy hold up throughout the rate cut cycle
Based on these factors, the Fed implements one of two rate adjustment paths:
Cutting By Choice
Also known as insurance, celebratory or mission accomplished cuts, this rate change path occurs when the Fed starts the rate cut cycle on its terms, usually when inflation has been tamed and the new risk is too restrictive for too long. Ideally the Fed comes to this conclusion with enough time to keep the economy on its current growth trajectory without inflationary risks reappearing.
Forced Cuts
Also known as pre-recession or panic cuts, this option occurs if economic growth has slowed significantly with a recession imminent, or a systemic or exogenous event forces the Fed to respond quickly. This option indicates the Fed is either already behind the ball or reacting to events well outside of its control.
With inflation near or at the Fed’s target and the economy still strong but slowing by some measures, the Fed is likely to use the cutting by choice path. Although it could have cut rates earlier, the economy is still showing resiliency and signs of being in a mid-cycle trend. With a more accommodative Fed, this long-term growth trend can continue and keep the bull market prospering. History has shown this is hard to do, but the trend in inflation and resilient growth indicates it’s possible.
Potential Impact on Markets and Asset Classes
The impact of the potential rate change to investment markets and asset classes revolves around two key timeframes:
- Rate cut cycle
- Post cycle plateau
During the rate cut cycle, bonds have largely outperformed stocks and real assets. The caveat is the Fed has largely been forced into rate cut cycles by negative events or poor economic trends. During these times, the market has largely reacted to and been representative of negative economic data, thus largely risk-off. Additionally, as rates fall, bond prices rise compounding their outperformance.
In cut by choice cycles, risk assets have outperformed other asset classes given the prolonged growth of the underlying economy. Bonds still performed well in these cycles given their rate sensitivity but have lagged equities and real assets.
After the rate cut cycle, longer term asset return trends are quite evident. Whether it’s one quarter or one year after the conclusion of the rate cut cycle, equities and real assets outperform bonds consistently.
The following types of investments can benefit from lower rates:
- Cyclicals over Defensives. Rely on sustained or increased spending from lower cost of funds and higher confidence in the economy.
- Small Caps. More sensitive to interest rates from their variable rate debt and depend largely on a healthy consumer. Any cracks in the economy can add additional risk.
- Bonds. Lower rates lead to capital appreciation in bonds and allow investors to lock in current rates with the possibility of capital appreciation in a low volatility asset class.
- Real Estate. Lower borrowing rates lead to more development, increase demand for commercial and residential properties as well as higher profitability on rental income.
How to Position Individual Portfolios
Rate cut cycles are a great reminder why diversification matters. How the cycle plays out and the economic backdrop can change quickly. Having allocations in different assets classes can minimize downside losses. Even during a soft landing, with a growth trend intact history shows that most asset classes have significant positive returns.
Portfolio rebalancing will become key during a rate cycle. Outsized moves in asset classes that tend to have lower volatility can easily distort a balanced portfolio. We believe that staying on top of or rebalancing can’t only reduce risk but position investors to take advantage of opportunities in other asset classes.
Adding to duration in bonds. With yields already coming down and rate cuts most definitely adding to that momentum, locking in higher rates for longer can help with the reinvestment risk that comes with a rate cut cycle. Additionally, falling yields lead to capital appreciation in bonds, which tends to help with the increased duration risk.
Respond Effectively in Volatile Environment
Rate cuts tend to bring volatility to the market which can make it hard to respond effectively. Investors frequently evaluate asset prices against benchmark interest rates and parse new commentary out of each Fed meeting. This rate cut cycle will begin in a landscape with additional volatility from seasonal, election year, and geopolitical factors.
On average, September has one of the lowest returns compared to other months, regardless of other factors. Add to this is an election year that brings heightened volatility, especially in the two months leading up to the actual election. Finally, we have a market near all-time highs and investor sentiment that’s leaning bullish.
These compounding effects lead to increased volatility which can quickly lead to overreactions and short term panicked moves in the market. Investors and traders are looking for reasons to sell regardless of true long-term effect on assets. Short-term pullbacks in this environment provide opportunity and have proven to be short lived.
We’re Here to Help
To learn more about how to prepare your portfolio for upcoming interest rate changes, contact your Moss Adams professional.