On Sept. 18, 2024, the Federal Open Market Committee (FOMC) lowered its benchmark interest rate by 50 basis points or 0.50%. The move made headlines because it was the first rate adjustment since July 2023 and the first rate reduction since March 2020.
The cut was prompted by improving economic conditions in the U.S. Inflation, which had driven the Fed’s rate increases in 2022 and 2023, fell below 3% in July 2024, and fell again in August and September 2024. With inflation nearing the Fed’s long-term target of 2%, investors largely expect a series of rate reductions from now through mid-2025.
The big question investors are asking is how these lower rates could affect their portfolios and investment strategies. Let’s take a closer look at how the stock market typically responds to falling interest rates.
When the Fed cuts interest rates, banks lower the rates they charge on loans made to their customers. On existing variable-rate debt, the reductions are immediate. In this case, business and consumer borrowers quickly benefit from lower ongoing interest expenses. New fixed-rate loans also get cheaper, but existing fixed-rate borrowings are not affected. Fed rate cuts can, however, create opportunities to refinance fixed-rate loans at lower interest rates.
In short, rate cuts lower the cost of borrowing. Cheaper debt is usually good for business, but the reason for the rate reduction influences how corporate leaders and investors respond.
Read more: What the Fed rate decision means for bank accounts, CDs, loans, and credit cards
If the Fed lowers rates because inflation is slowing, the response should be positive. Businesses are likely to pursue growth more aggressively. Investors, expecting higher earnings ahead, may funnel more capital into the stock market. This can push stock prices higher.
Lower rates can negatively affect the stock market when they are prompted by an economic slowdown. When the economic outlook is uncertain, corporate leaders and investors can be more cautious about investing in growth.
According to Robert R. Johnson, CEO and chair of active index strategy developer Economic Index Associates, “historically speaking, equities perform substantially better when the Fed is lowering rates rather than when the Fed is raising rates.”
Learn more: What is the Federal Reserve?
Investor expectations heavily influence stock prices. For this reason, the effects of a rate change usually begin well before the Fed acts.
When investors expect a rate reduction and the economic outlook is good, stock prices rise. Once the Fed implements the cut, the after-effects can be minimal. The exception is if the rate reduction is more or less aggressive than investors had expected. In that case, the market may shift again as investors adjust to new circumstances.
Learn more: Your step-by-step guide to investing
Johnson, who has extensively studied how the Fed’s policies affect stock market returns, identifies the best-performing sectors when interest rates are falling as autos, apparel, and retail.
Johnson also sees opportunity in real estate investment trusts or REITs, particularly mortgage REITs. “With rates expected to continue to fall in 2024 and beyond, both equity REITs and mortgage REITs could be attractive investments,” Johnson said.
Learn more: How to invest in real estate: 7 ways to get started
David Russell, global head of market strategy at trading platform Tradestation, expects lower rates to benefit cruise ship operators and airlines. “They’re economically sensitive and have significant debt loads,” Russell said. “Lower inflation will help their profitability, while lower rates could reduce their borrowing costs.”
To summarize, lower interest rates are particularly good for real estate values and companies that rely heavily on debt or discretionary consumer spending.
Investors routinely adjust their holdings and trading behaviors according to their economic outlook. This is evident in the market movements that follow reports on inflation, jobs, and gross domestic product.
Learn more: Jobs, inflation, and the Fed: How they’re all related
As an example, the S&P 500 experienced a single-day decline of 3% in early August 2024 after a disappointing July jobs report sparked recession worries.
Market shifts prompted by investor-sentiment trends can encourage many to wonder what moves they should be making ahead of Fed-rate actions. The right answer depends on the investor’s timeline and strategy.
Learn more: When is the Fed’s next meeting?
Investors who need to maximize income or growth within a relatively short timeline may see the opportunity to adjust holdings according to the interest rate climate.
Commonly, this involves shifting exposure between stocks and bonds. Bonds are favored when interest rates are rising, while stocks become popular as interest rates fall.
On the other hand, long-term investors with high-quality, diversified portfolios may want to avoid big changes in response to rate adjustments. Overhauling a portfolio based on temporary conditions can easily undermine results over time.
Lane Martinsen, founder and CEO of Martinsen Wealth Management LLC, describes the dangers of making short-term decisions for long-term portfolios.
“Reacting to rate changes can lead to emotional decision-making, which can harm long-term performance,” Martinsen said. “Frequent buying and selling to ‘time’ the market often results in higher costs, taxes, and missed growth opportunities.”
Long-term investors might instead rely on changing economic conditions to prompt periodic reviews of their portfolio composition or asset allocation. If the allocation is performing and the risk profile is acceptable, few to no adjustments are needed.
Still, a proven allocation strategy may allow for small changes to improve performance as interest rates evolve. In this scenario, Johnson recommends adjusting sector exposure.
Specifically, when interest rates are expected to drop over time, investors could reduce financial and utilities holdings while increasing exposure to autos, apparel, and retail — sectors that have historically shown strength in falling rate environments.
Investors can implement sector-based adjustments without changing their relative exposures to broader asset classes, such as stocks, bonds, and alternative assets. Doing so should keep the portfolio’s risk and appreciation potential fairly stable, which is critical for long-term growth.
If economic conditions continue to improve, we could see serial interest rate reductions over the next six to eight months. Frequent traders may want to invest more heavily in stocks over bonds as a result. Long-term investors can benefit from smaller sector adjustments that do not conflict with their existing, proven allocation strategies.
