After a steep rate hike cycle in which the Fed raised rates eleven times between March of 2022 and July of 2023, for a total increase of 5.00%, rates have been on hold for the last six FOMC meetings as the Fed has assessed the success of the fight against inflation. With that battle (likely) won, rates are likely to come back down during the potentially new interest rate cycle.
While the new cycle will likely play out over many months, rate decreases herald a looser, more “dovish” monetary policy with a different goal than curbing inflation by moderating growth. This time, the Fed wants to balance inflation with strong employment and a growing economy. In other words, the breaks are coming off a bit.
How will this impact investors? The first thing to remember is that you should have a long-term, well-diversified investment strategy in place that is positioned to take into account monetary cycles, business cycles, and even shocks to the economy. There shouldn’t be any need to make big sweeping changes.
Even if you want to make changes, take them slowly and allow time for policy to evolve. There are no guarantees of what the Fed will do or when they will do it, so even if you want to change things up because your situation or your goals have changed, be aware that the inflection point for monetary policy will bring volatility and may heighten risk, so take a measured approach that allows time for assessment.
That said, there are some tune-ups you may want to make to your portfolio. As always, though, it’s important to think about the opportunities in the context of your goals and your risk tolerance.
Lower Rates Mean Low-Risk Investments Will Have Lower Return
With the key short-term interest rate at a little over 5%, investments like CDs have been a rewarding place to put funds that you don’t need in the short term. Locking up the money for six, twelve or 18 months was worth it to have a high rate of return for very low risk.
However, with rates poised to go lower, those investments will pay less. Locking in these higher rates now for money you won’t need over the next year can make sense but think carefully about the tradeoffs.
Adjusting for Lower Rates
When the cost of money decreases, consumers and businesses alike feel more confident about spending, which gooses the economy. But the impacts on stocks and bonds are not evenly distributed, so some choices and adjustments need to be made.
Lower interest rates mean that bond yields usually decline, which makes newly issued bonds oftentimes less valuable. When rates are rising, investors shorten the duration of their bond portfolio. Duration is a measure of the sensitivity of a bond’s price to interest rate movements. Generally, the higher the duration, the more a bond’s price will drop as interest rates rise. The reverse can be true in a falling interest rate environment, as bonds with longer durations may benefit from more price appreciation.
However, longer durations incur more interest rate risk, so if the Fed were to reverse course and unexpectedly raise interest rates – for example, if inflation were to bump back up – long-duration bonds would be more vulnerable.
Replacing Sources of Income
As bond yields decline, investors who are dependent on their portfolios for income may want to pivot to different sources. Dividend-paying stocks may be more attractive in this environment. These stocks focus on paying a steady dividend to investors. They are often found in sectors with more stable demand, like utilities, consumer staples, energy, and healthcare.
Positioning for Increased Growth
Some sectors may benefit from the lower cost of capital. Consumer discretionary stocks may see increased consumer demand, people have more access to goods that are “nice to have” rather than “need to have”, like consumer staples. Industrials may benefit, as companies are able to lower the cost of their debt, which may boost their stock prices and help them expand. Technology, particularly the Magnificent Seven stocks, has been dominating the stock market despite higher rates, and lower rates may extend this trend. In terms of capitalization, small-cap stocks may also benefit as the lower cost of funding allows more growth and flexibility to their business models.
The Bottom Line
A new monetary policy regime will have impacts across the economy and for investors. Taking a measured approach to making changes can help you stay on track, manage risk, and potentially capture new opportunities.
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