The Fed Cut Rates. What Comes Next?
Summary
September may have marked the beginning of the newest cycle in which the Federal Reserve cuts rates. Short-term rates continued to fall in every prior period. But changes in longer-term rates have been more muted and more challenging to predict.
The impact from rate cuts will likely depend on one’s perspective. Falling short-term interest rates are likely to impact savers, investors, and borrowers differently.
Investors and homeowners could consider past market reactions from past cycles to help guide decisions concerning today’s environment, keeping in mind past performance does not guarantee future results.
The Federal Reserve cut interest rates for the first time since 2019 last month.
Many are wondering if rates will fall further, and if so, what to do about it.
We recently wrote about how stocks, bonds, and real estate have performed during periods in which the Fed was reducing rates. Click here if you would like to read.
The Fed has a dual mandate – maintain stable prices (i.e., low inflation) and promote maximum employment (i.e., few workers actively looking for jobs). Recent data suggests inflation seems to be cooling, and the labor market appears to be doing the same.
The Fed’s target range for the Fed Funds rate is now 4.75%-5.00%. Markets think the the Fed Funds rate will continue to fall through next year. Will they be right?
Short-term rates have continued to fall
We can start by looking at the past for some direction.
The Fed has been in rate-cutting-mode seven times since 1982. If we look at the date of the first rate cut and then fast forward 90 and 180 days (about 6 months), their target rate continued to fall every time. The chart below shows how much further rates fell in those seven earlier cycles.
Savers should potentially take note, as they are the group most likely to be hurt if short-term rates go lower.
The yields on things like money market funds and savings accounts are likely to fall if this cycle follows historical trends. Earning 5% or more on idle cash was great, but those days may be behind us for now.
Before making any quick decisions to move money out of those investments, consider the original purpose. If they are emergency savings, or intended to pay for some upcoming expenses, no action may be the right action.
Longer-term rates have usually fallen, too, but not as much as short-term rates
The Fed has a lot of control over short-term rates, while market participants have more influence on longer-term rates.
Long-term interest rates might matter more to someone borrowing to buy a home for 15 or 30 years, or someone who hopes to generate income from their investments. Here is summary of how longer-term rates have behaved in previous cycles.
• Yields on 10-year U.S. Treasury bonds have followed a similar pattern of moving lower, but not always.
• 10-year yields went higher for 30 days after the first Fed rate cut in 1995, and they rose over the next six months in 2001.
• During the most recent cutting cycle in 2019, 10-year yields barely budged.
While it seems likely long-term rates move lower from here, nothing is guaranteed.
Steeper Seems Likely
The Fed typically cuts rates to stimulate the economy, making borrowing money less costly and investments in long-term productive projects more attractive. In previous cases, the Fed has needed to cut short-term rates aggressively to stimulate softening labor markets and weakening economic growth.
Charts 3 and 4 below show just how much short-term rates, which the Fed can influence, have fallen, compared to longer-term rates, for which the market has greater influence.
Short-term rates like the Fed Funds rate have typically fallen much more than longer-term rates after the first rate cut.
Another way to visualize this relationship is by looking at changes in the yield curve. The yield curve simply plots interest rates for different maturities. A “normal” yield curve slopes up and to the right, as longer-term bonds have higher yields than shorter-term bonds. An “inverted” yield curve slopes down and to the right, with short-term yields being higher than longer-term yields.
The chart from the St. Louis Fed shows one example of a yield curve, plotting the difference between 10-year and 3-month Treasury yields, in green. The orange line shows the effective Fed Funds rate.
When the orange has been falling, i.e. during rate cutting cycles, the green line usually rises. This means the yield curve is getting “steeper.”
This is just another way of saying short-term rates typically fall faster than longer-term rates
Implications for investors and homeowners
If you are reading this, and you made it this far, I bet the chances are good you are considering if your investment strategy should change now that the Fed has started cutting rates. Or maybe you are thinking about buying a home and wondering how mortgage rates are likely to move.
Again, we can look at the previous cycles for some guidance.
The table below shows the performance of U.S. stocks and bonds. The final two columns are the most interesting to me, looking at the six- and twelve-month periods after the first rate cut in different cycles. The best and worst periods for each time frame are highlighted green and red, respectively.
Stock returns were positive in all but two periods. The exceptions came in 2001, following the technology-driven bull market from the late 1990s, and 2007, leading into the global financial crisis.
When 1-year stock returns were positive, they tended to be quite strong, ranging from 11% to 44%.
Bonds, as you might suspect, had positive returns in every 3-month, 6-month, and 1-year period. Bond prices tend to rise as interest rates fall.
US Stocks represented by the S&P 500 Index, including dividends. Bonds represented by the Bloomberg US Aggregate Bond Index.
Finally, let’s mention housing.
Recent rate cuts spurred activity in the housing market. Mortgage applications recently hit their highest level in two years. The average 30-year fixed mortgage rate has fallen from a recent high of 7.8% to about 6.4%.
We talk to a lot of homeowners who either feel trapped in their current home because they refinanced their mortgage when borrowing rates were around 3%, or who have been waiting to buy until mortgage rates came down a bit.
This chart from the St. Louis Federal Reserve shows 10-year U.S. Treasury yields in orange, 30-year fixed mortgage rates in green, and the effective Fed Funds rate in light brown. While all three lines have generally moved in the same direction, mortgage rates have been more highly correlated to changes in these Treasury yields than Fed Funds rates.
For those wondering if mortgage rates will fall further, it may be wise to pay attention to yields on longer bonds.
Summary
The Fed’s 0.50% cut in September potentially marked the beginning of a new rate cycle. If history repeats, interest rates seem likely to fall further in the months ahead. And short-term rates are likely to fall further than longer-term rates.
Savers – those with the majority of their money in savings accounts, certificates of deposit, money market accounts, or something similar – could be hurt most by lower rates, as the income from those investments is likely fall.
US stocks have generally fared well following the first rate cut, with a couple notable exceptions, while bond returns were consistently positive. As always, past performance does not guarantee future results.
Interested in talking more?
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