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No one can exactly predict the direction of interest, although we can make educated guesses.
According to a recent article in Fortune, analysts at Citi Research believe the Federal Reserve could cut interest rates by 200 basis points over eight consecutive meetings. This would involve eight reductions of 25 basis points each, starting in September and continuing until July of 2025.
The bond market is pricing in 100% probability of a rate cut on September 18 2024 when the Federal Reserve meets. It’s now currently priced in an 85.5% expectation of a 50 basis point cut and a 14.5% expectation of a 75 basis point cut.
The Federal Funds rate, or the Fed rate, is the interest rate that U.S. banks pay one another to borrow or loan money overnight. It also affects interest rates on everyday consumer products, such as credit cards or mortgages.
The Federal Reserve typically cuts rates due to concerns about a slowing economy if they see data that shows a weakening job market or lower consumer spending.
Stock Prices and Falling Interest Rates
After the Federal Reserve lowers rates, markets may initially react positively to rate cuts because this indicates that borrowing will become cheaper.
When interest rates go down, stocks tend to become relatively more attractive compared to fixed-income investments. That’s because the lower yields on bonds and savings accounts push investors towards stocks in search of higher returns.
We can go back a few years and see look the low interest rate environment prior to the Federal Reserve raising rates in 2023. With interest rates near zero from 2020 to 2022, traditional safe-haven assets like bonds and savings accounts gave investors extremely low yields. This pushed investors to seek higher returns in riskier assets like stocks.
Driven by this backdrop, the S&P 500 index went up 24% in 2023. We can also see how this played out in previous periods of Federal Reserve rate cuts:
| Period | Federal Funds Rate Cut | S&P 500 Performance |
| 2001 Rate Cut Cycle | 5.5 percentage points | +21% (12 months after first cut) |
| 2007-2008 Financial Crisis | 5.0 percentage points | Initially negative, +23.5% in 2009 |
On average, the S&P 500 had modest gains around Federal Reserve interest rate cuts, where it rose around 4% in the year preceding the first cut and around 7% in the year following.
So, stock prices tend to rise after rate cuts which is good if you’re investing in stocks for the long term.
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Stocks Down, Bonds Up Effect
One pattern that we’ve also seen playing out when interest rates drop is known as the “stocks down, bonds up” effect.
This pattern refers to the inverse relationship between stock and bond prices during periods of economic uncertainty or market stress. This has played out during previous economic downturns such as the 2008 Financial Crisis when stocks crashed while U.S. Treasury bonds rallied. This also happened during the 2020 Pandemic when the initial market shock saw a sharp stock sell-off and bond prices surged.
Rate cuts are typically intended to stimulate economic growth. But the reasons behind rate cuts are actually what leads to market concerns. The rate cuts themselves aren’t the reason for stocks to fall but it’s the perception by investors that drive market reactions.
The initial drop in stocks typically occurs because rate cuts often signal economic concerns, which can temporarily spook the market. But as the stimulative effects of lower rates begin to play out in the economy, stocks tend to rebound.
You can use this effect to your advantage. The initial stock market drop following interest rate cuts can give you good entry points to buy stocks. Keep an eye on the Federal Reserve announcements and economic indicators that might signal coming interest rate cuts.
Hold a diversified portfolio with a mix of stocks and bonds which can manage portfolio risk. Focus on high-quality stocks and bonds such as U.S. Treasuries, which tend to hold up much better during market downturns.
Also, consider shifting towards defensive sectors like utilities, consumer staples, and healthcare, which tend to be less volatile than growth stocks.
If you have an allocation of bonds in your portfolio, consider holding long-term bonds when interest rates are expected to fall. Long-term bonds are more sensitive to interest rate changes and see more price increases when rates drop compared to shorter-term bonds.
Rotation to Small Cap Stocks
Interest rates and stock prices generally have an inverse relationship. When interest rates fall, borrowing costs decrease, making it cheaper for companies to finance expansion and operations.
When interest rates fall, small-cap stocks can especially benefit because smaller companies typically have higher levels of debt compared to larger companies, making them more sensitive to changes in interest rates.
We can see that the Russell 2000 Index, which tracks small-cap stocks, has gone through periods of outperformance relative to the S&P 500 Index, which tracks large-cap stocks:
- 1979-1983: During this period of double-digit inflation and interest rates, the Russell 2000 outperformed the S&P 500 by 80%.
- 1990-1994: After the 1990-91 recession, small-cap stocks outperformed large-cap stocks by nearly 50%.
- 1999-2014: During this turbulent period which included 9/11 and the 2007 Great Financial Crisis, the Russell 2000 outperformed the S&P 500 by 114%. Small-cap stocks were boosted by the economic recovery and quantitative easing measures.
More recently, in anticipation of potential rate cuts by the Federal Reserve later this year, the Russell 2000 Index returned 9.8% in July this year.
Some financial pundits expect that small cap stocks will see an increase in annualized profit growth each quarter through year-end, which is the opposite of what is expected for the Magnificent 7 stocks (Apple, Microsoft, Alphabet, Amazon, NVIDIA, Tesla, and Meta Platforms).
Also, certain sectors within the small-cap universe tend to perform better during periods of falling interest rates such as real estate. Lower interest rates reduce borrowing costs, which tends to boost real estate investments and related stocks.
Bonds and Falling Interest Rates
When the Federal Reserve cuts rates, bonds tend to become more attractive. That’s because when interest rates fall, existing bonds with higher yields become more valuable.
This inverse relationship between bond prices and interest rates can create opportunities for investors to profit from capital appreciation and higher yields compared to newly issued bonds.
Historical data shows the positive impact of falling rates on bond performance.
| Period | Federal Funds Rate Cut | 10-Year Treasury Yield Decline | Long-Term Government Bond Returns |
| 1981-1982 Rate Cut Cycle | 10.5 percentage points | ~4.6 percentage points | +40.4% |
| 2001 Rate Cut Cycle | 5.5 percentage points | ~1.6 percentage points | +4.3% |
| 2007-2008 Financial Crisis | 5.0 percentage points | ~1.8 percentage points | +22.5% |
Yields on Treasuries tend to be lower than those of corporate bonds, but they provide a reliable income stream guaranteed by Uncle Sam. Treasury bonds are also highly liquid, which means they can be bought and sold without impacting their price.
If this strategy appeals to you, consider buying long-term bonds, or bonds with longer durations, which benefit more from falling rates compared to short-term bonds.
Another way to invest in bonds is through bond mutual funds and ETFs. These funds can take advantage of market movements more effectively than most individual investors. As bond yields move inversely to prices, lower rates could mean better returns for well-managed funds.
The Real Estate Market
When interest rates fall, the real estate market often sees major shifts. Lower rates typically stimulate property prices and affect rental yields. In a falling interest rate environment, property prices tend to rise because lower mortgage rates make buying a home more accessible, and buyers can afford more expensive properties with the same monthly payment.
In the early 2000s, Federal Reserve Chairman Alan Greenspan reduced interest rates drastically to stimulate the economy after the dot-com bubble burst and the 9/11 attacks. The Federal Funds rate dropped from 6.5% in 2000 to 1% by mid-2003.
This led to much lower mortgage rates and a housing boom. Later, the Federal Reserve began raising interest rates in 2004 to cool the real estate market, but the housing bubble continued on until it burst in 2007.
In 2020, the Federal Reserve lowered interest rates in reaction to the Pandemic, which again, led to a big spike in property prices. The National Association of Realtors reported that existing home sales increased by 22% in 2020 compared to the previous year.
Here are some ways to take advantage of falling interest rates in the real estate market:
- If you have existing properties, you can refinance your mortgages at lower rates.
- With lower interest rates, you can purchase rental properties with lower financing costs, and increase your rental income margins.
- Real Estate Investment Trusts (REITs) tend to perform well during periods of falling interest rates. This is because REITs benefit from lower borrowing costs and increased property values.
Fixed Deposit and Savings Rates
You may have begun noticing that banks have already been anticipating potential rate cuts. For example, early in the year, you could find 5.30% savings rates at some banks. But today, you’ll see these are down to around 4.00% to 5.00%.
Fixed deposit and savings account rates are influenced by the federal funds rate. When the Fed lowers rates, banks typically follow and reduce the interest rates they offer. Banks are likely to start lowering rates in late August and early September, ahead of the Federal Reserve’s meeting on September 18.
With the Federal Reserve signaling a potential decrease in interest rates, now could be a good time to lock in higher rates on fixed deposits and savings accounts. If you lock in a fixed deposit in a 12 month certificate of deposit, you’ll secure higher returns before the anticipated rate cuts happen. Also, online banks tend to offer much higher rates compared to traditional banks.
Private Equity Investments
Another area that is less discussed when interest rates fall is the private equity markets. Lower interest rates can benefit private equity (PE) firms in terms of their PE strategies, deal structures, and overall returns.
If you’re considering investing in PE investments, whether direct investing or through a fund, here are some areas within PE investments to keep in mind during falling interest rates:
- Leverage Buyouts (LBOs): Lower borrowing costs tend to boost leverage and returns.
- Growth Capital: Lower rates can stimulate economic growth, which can support high-potential companies.
- Companies Refinancing: Lower rates can reduce debt expenses and improve cash flow for companies.
- Exit Opportunities: A lower interest rate environment can make PE investment exits easier through strategic buyers.
Falling or lower interest rates can create opportunities in the market for savvy investors, but you need to keep a close eye on the direction and broader economy.
