Guide on Investing Ahead of a Potential Federal Reserve Interest Rate Decrease
Lower Interest Rates Boost Growth Stocks and Pressure Fixed Income
In a recent development, the Federal Reserve did not make any major moves at its July 29-30 meeting, but traders are pricing 61.5% odds that interest rates will be lower after the late October meeting [2]. This potential rate cut could have significant implications for various asset classes.
In a falling-interest-rate environment, growth stocks, particularly tech, small-caps, and other companies dependent on expectations of future earnings, tend to benefit most [1]. This is because lower interest rates stimulate economic growth by reducing borrowing costs for companies, improving profit margins, and increasing corporate earnings, making stocks more attractive relative to bonds [3].
Capital is cheaper in a falling-interest-rate environment, reducing the cost of capital for young, fast-growing companies [4]. Tech stocks and small-cap stocks, as well as other high-growth sectors, may get a tailwind when the Fed starts cutting interest rates again [5].
However, it's important to note that while falling rates generally boost stocks and hurt income from bonds and savings, rate cuts often occur during economic slowdowns, which can have mixed effects on markets overall [1][3]. Investors should maintain diversification and manage risk rather than chase momentum blindly.
Lower interest rates have several key effects on investors across different asset types:
- Bonds: As interest rates fall, bond prices generally rise because the fixed interest payments become more attractive compared to new bonds issued at lower rates. However, the yields on new bonds and savings products also decline, reducing income for investors relying on fixed income [1][4].
- Savings accounts and CDs: Lower rates mean lower yields on savings accounts, money market funds, and certificates of deposit (CDs). This pushes income-focused investors to seek higher returns in other areas, potentially taking on more risk [1][2].
- Stocks: Lower interest rates make stocks more attractive relative to bonds, boosting corporate earnings and improving profit margins [3].
- Certain sectors like tech and small-caps: These sectors tend to receive a significant tailwind from lower rates since they depend on external funding and have earnings that are more weighted in the future [1].
It's worth mentioning that longer-term bonds with maturities of 10 years to 30 years may offer higher yields [6]. The probability is better than 85% for a rate cut by the December 10 meeting [7], and as of July 30, the CME Group's FedWatch tool shows a 41.3% chance of a 25 basis points rate cut following the next meeting [2].
In conclusion, a decline in interest rates often leads to a rally in growth-oriented stocks, especially in tech and small-cap sectors, while pressuring fixed-income instruments and savings yields [1][2]. Investors should stay informed about the Fed's decisions and adjust their portfolios accordingly, while maintaining a balanced approach and considering the potential risks involved.
[1] Investopedia. (2021). How Do Lower Interest Rates Affect the Stock Market? https://www.investopedia.com/ask/answers/112215/how-do-lower-interest-rates-affect-stock-market.asp
[2] CME Group. (2021). FedWatch Tool. https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
[3] The Balance. (2020). How Do Interest Rates Affect the Stock Market? https://www.thebalance.com/how-do-interest-rates-affect-the-stock-market-4160383
[4] Investopedia. (2021). Capital Cost. https://www.investopedia.com/terms/c/capitalcost.asp
[5] The Balance. (2020). How Do Interest Rates Affect the Stock Market? https://www.thebalance.com/how-do-interest-rates-affect-the-stock-market-4160383
[6] The Balance. (2020). How Do Interest Rates Affect the Stock Market? https://www.thebalance.com/how-do-interest-rates-affect-the-stock-market-4160383
[7] CME Group. (2021). FedWatch Tool. https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
Investing in growth stocks, such as tech and small-caps, becomes more compelling as interest rates fall, since lower rates reduce the cost of capital for these fast-growing companies (Capital cost). On the other hand, fixed income investors may experience pressure as lower rates reduce income from bonds, savings accounts, and CDs (Savings accounts and CDs).
