Three Implications of the Fed’s Anticipated Interest Rate Cuts – From Investors’ Perspective

No institution arguably has more influence over our economic lives than the Federal Reserve (the Fed), which serves as the central bank of the United States. Contrary to what its name might suggest, the “Federal” Reserve is not a government entity but an independent central bank that is owned by its member banks, including familiar names of JP Morgan Chase, PNC, and Bank of America. It wields power, to the extent that investors scrutinize the importance of every word uttered by the Fed’s Chairman, which can dictate market movements.

Despite the potential negative connotations associated with the Fed’s significant power, their primary mission is to ensure economic stability, for the benefit of businesses and individuals. They do so by using the monetary policy, which controls the level of the money supply within the economy. In the last few years, the federal funds rate, the short-term interest rate set by the Fed, and one of the monetary policy tools, has been a focal point among investors. As we expect interest rate cuts to begin this year, based on comments from the Fed’s chairman, Jerome Powell, who has indicated that the current interest rate of 5.5% is likely the peak for this economic cycle, we will examine three implications of such cuts, from investors’ perspective.

1. Asset Prices, Particularly Bond Prices Will Likely Rise

Lower interest rates make borrowing less expensive, leading to an increase in money circulation within the economy. This influx of capital tends to flow into financial markets, including stocks, bonds, and real estate, thereby driving up their prices. 

While predicting stock price movements is not feasible, as studies have shown, the anticipated rise in bond prices from interest rate cuts is more certain due to their structures. A bond is a loan composed of three important elements – principal, duration and the interest rate, which are the initial borrowed amount, its payback period, and compensation to creditors for the risk they take and other investment opportunities they forsake. Further, the change in the interest rate determines the prices of bonds sold in the market. 

When the interest rate falls, bond prices rise. For example, before the interest rate cut, investors could buy bonds with a yield of, say, 5%. However, after the interest rate cut, new bonds have a yield of only, say, 4%. In this scenario, new investors seeking interest payments higher than 4% from bonds must acquire them from holders of pre-cut 5% bonds. These 5% bonds are sold at a premium because the new issues available to investors are yielding only 4% interest. This situation is similar to how people pay above the original retail prices for highly sought-after and discontinued goods, such as luxury watches. However, it’s important to note that bonds differ from such goods since they are not investments and do not generate cash flows.

2. Investors Will Seek Higher Returns in Risky Assets

With the Federal Reserve’s interest rate hikes, which started in 2022, returns on short-term securities like money markets, increased. As interest rates climbed above the rate of inflation, they became a lucrative and risk-free savings vehicle.

Unlike bonds, money markets are not subject to the same fluctuations due to their short-term nature, which includes inter-bank overnight borrowings. They are considered risk-free as the government would have to default on its debt obligations for them to become worthless. Currently, they are yielding approximately 5% in interest, which is the highest rate since the beginning of the 21st century.

However, as the Fed raises the interest rate, it also increases the cost of borrowing for the US government, which can have significant implications for the country’s future solvency. To ensure the sustainability of debt service, there is growing pressure on the Fed to lower the interest rate.

As the rate drops, money market yields will decline accordingly. As the yields lower towards the rate of inflation, investors may look for riskier assets, including stocks and lower-grade (riskier) bonds for higher returns. 

3. The Rate of Inflation Will Increase 

Interest rate cuts by the Fed not only bolster asset prices but they can also raise the general cost of living even further, thereby compounding the effects of inflation we have experienced in the last few years.

The Fed’s objective is to maintain a 2% annual inflation rate target to stimulate the economy without causing substantial price increases. However, in 2023, the inflation rate exceeded this target, reaching 3.4%. Since the Fed’s chairman Mr. Powell stated the Fed would not wait until the inflation comes down to 2% before they make the first interest rate cut, potential subsequent rate cuts may exacerbate the inflationary pressure, reducing the value of cash further.

At a hypothetical 5% inflation rate, cash that is not invested will decrease in value each year. In five years, $100,000 in one’s checking account will be worth $77,378, representing an 18.5% cumulative loss in purchasing power. At a 6.5% inflation rate, the loss will be 23.6%. Even at a relatively modest 3.5% inflation rate, the value of cash will decrease by 13.3% in five years.

How Investors can Respond to Falling Interest Environment

Because of these implications of interest rate cuts, investors may be compelled to take on additional risks. An aggressive investor might opt to invest mostly in stocks, while a conservative investor might choose a combination of money market and bonds. Although the specific investment approach may vary based on an individual’s investment objectives, it will be crucial to allocate more funds to financial assets, before the rate cuts begin and the effects of inflation take hold, despite recent years of market volatility.

Investors who bought bonds just before the start of interest rate hikes in 2022 saw their value decrease, as it marked the worst-ever year for the bond market. However, since the Fed suggested the halt of interest rate hikes in late 2023, bond prices have recovered from their bottom, as they started to factor in the future rate cuts. Due to the bonds’ structures, events of interest rate cuts will likely further appreciate their prices. For this reason, current bond holders may benefit from their potential rise in prices. 

In light of the current interest environment, I recently moved much of my cash that I anticipate to use in the near future, to a money market mutual fund that currently yields 5% interest, while leaving some of it for emergencies. As interest rate cuts will change the investment environment, it necessitates investors to take appropriate actions. 

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