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 the 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: minimize unemployment and stabilize inflation.
The Fed does this is by decreasing or increasing interest rates.
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, stagnating job growth,
or increasing prices of everyday goods the Fed may decide to lower interest rates.
Specifically, the federal funds rate.
Generally, when the federal funds rate is low, banks lower their interest rates.
This can help stimulate economic growth in a couple ways.
First, lower interest rates make it cheaper for people and businesses to borrow money
for big purchases or new ventures.
Second, cutting interest rates 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.
However, it'll likely be some time after the Fed cuts rates before consumers begin
to feel this type of economic growth.
Though the economy responds slowly, you may see changes in the stock and bond markets
immediately.
For major stock indices, rate cuts are typically good news.
While expectations are often priced in, sometimes there's a surprise that can cause the market
to spike.
In fact, sometimes just rumors of cuts can cause a rally.
For example, in June 2019, Fed chairman Jay Powell assured that the Fed would act as
appropriate to sustain the expansion, many investors interpreted this as a hint that
interest rates could be cut.
As a result, stocks soared, and the Dow broke its six-week losing streak.
In general, the S&P 500 Index has generally performed well following interest rate cuts.
This may be partially due to economic recovery but could also be due to investors' increased
optimism.
Interest rate cuts can also have a major impact on the bond market, driving demand for bonds
higher.
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.
Over the past 46 years, the performance of stocks, commodities, REITs, and gold was relatively
balanced.
But during low interest rate environments, REITs and U.S. stocks have been the highest
overall performing asset classes.
Because interest rates are typically cut during economic slowdowns, defensive stock sectors
may be better poised to weather low interest rate environments.
Think of it this way reduced rates in bonds may cause investors to look for income streams
elsewhere.
This can cause increased demand for stocks that are known for their steady dividends,
like real estate, utilities, and telecom.
Consumer staples may also be a good investment during a rough economy because people will
always need food.
Plus, these stocks tend to pay dividends as well.
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.