Upbeat music plays throughout.
Narrator: Speculation about whether the Fed will cut interest rates can generate a lot of headlines, but it's not always clear how a rate cut might affect investors.
So, let's discuss how lowered interest rates can stimulate the economy and impact financial markets. Also, let's take a look at which types of investments have historically performed the best in low-interest-rate environments.
The goal of the Federal Reserve, or the Fed, is to keep the U.S. economy healthy in two ways: maximizing employment and stabilizing inflation.
One of the ways the Fed does this is by decreasing or increasing interest rates.
Animation: Chart shows the federal funds rate during seven recessions. The peak rate occurred in the early 1980s, and the lowest rates, near or at zero, occurred in the 2010s and early 2020s.
Narrator:
Historically, as the economy has shown signs of weakness, the Fed has responded by cutting interest rates.
Here's how it works: A committee within the Fed, called the Federal Open Market Committee, meets eight times a year to look at the health of the economy.
If there are signs of a weak economy—like rising unemployment and stagnating job growth, the Fed may decide to lower interest rates. Specifically, the federal funds rate.
Generally, when the federal funds rate gets lower, banks lower their interest rates on loans. These lower loan rates can help stimulate economic growth in a couple ways. First, they can make it cheaper for people and businesses to borrow money for big purchases or new ventures.
Secondly, banks also typically lower rates on CDs and savings accounts, which makes it less profitable to keep money in bank accounts. Instead of saving, individuals and businesses may want to invest or spend that money.
The goal is to kick-start a virtuous cycle of spending and growth that creates jobs and steers inflation to more healthy levels.
While it'll likely be some time after the Fed cuts rates before the economy starts to respond, you may see changes in the stock and bond markets immediately.
Animation: Chart showing the return of the S&P 500® Index in the 12 months following the first rate cut in 14 rate cut cycles from November 1929 through July 2019. All but two (Jan 2001 and September 2007) had positive returns, ranging from 3.3% in 1929 to 35.1% in 1954.
Narrator:
Historically, the S&P 500® index has generally performed well following interest rate cuts. In fact, the 12 months after the first cut have been positive for the index—to varying degrees—86% of the time since 1929. This may be partially due to economic recovery but could also be due to stocks becoming more appealing to investors as returns on other assets fall due to lower interest rates. In particular, stocks that are known for their steady dividends—like real estate, utilities, and telecom—may lure investors away from lower-yielding fixed income investments.
Interest rate cuts can also have a major impact on the bond market.
This is because if interest rates are going to be lower, older bonds with higher interest rates become more valuable. For investors who already own bonds, interest rate cuts can potentially allow them to sell their bonds for a higher price on the secondary market.
Animation: Chart showing average performance of asset classes 1976 through 2023. U.S. stocks and REITs were the top performers and commodities and gold were the lowest both overall and during low interest rate environments.
Here, you can see the overall performance of international and U.S. stocks, commodities, REITs, bonds, and gold from 1976 through 2023. During low interest rate environments, REITs and U.S. stocks have historically outperformed other asset classes.
While stock markets often initially welcome rate cuts, if the cuts are accompanied by prolonged economic weakness, the cuts can lose some of their market-moving muscle. In short: Low rates don't guarantee a bull market for stocks. If economic weakness continues or tips into recession, the stock market could suffer. Defensive stock sectors like consumer staples may be better poised to weather economic slowdowns. People always need food.
But remember, the point of cutting interest rates is to nudge the economy in the opposite direction. Though cuts may be the result of a negative economic outlook, forward-thinking investors may want to anticipate how interest rate cuts may help spur long-term economic growth.
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