At the latest U.S. Federal Reserve meeting on July 30-31, the central bank held its federal funds rate steady at a 23-year high of 5.25%-5.50% – just as it has done at each of its previous six gatherings.
But after this period of stability – and signs inflation is easing and the labor market is cooling – it appears as if the Fed is poised to reverse course and potentially begin cutting interest rates at its upcoming meeting that starts this Tuesday, September 17.
But if the Fed is about to cut rates, what should investors do?
Fed interest rates: a brief history
The current level of interest rates is objectively higher than it has been over the last two decades or so. As the housing market crashed in 2007, the Federal Reserve began an aggressive period of rate cuts that brought the federal funds rate from 4.75% down to nearly zero. That helped prop up the stock market during the next several years – after the initial mayhem passed, of course.
Near-zero rates lasted until December 2015, when a slow but gradual series of rate increases began. Those moderate moves did not disrupt the stock market's growth, and the trend of higher rates lasted through the end of 2018 when the effective federal funds rate reached a peak range of 2.25% to 2.50%. However, the COVID-19 pandemic forced a return to near-zero interest rates in response to the economic crisis that was unfolding at the time.
A second round of increases at the Federal Reserve began in earnest in March 2022 in response to spiking inflation. The central bank proceeded to hike rates 11 times over the next 16 months, bringing the federal funds rate to its current level.
But even amid this aggressive tightening, the stock market proved resilient, with the S&P 500 Index up 163% on a total return basis (price change plus dividends) since March 2022.
What should investors do if the Fed cuts rates?
The Federal Reserve is notoriously tight-lipped about its policy forecast. However, its Summary of Economic Projections, or "dot plot," summarizes what each member expects monetary policy to be going forward. Based on the outlook published in June, most central bankers anticipated, at that time, one quarter-point cut to the federal funds rate this year, with four more in 2025 and another four in 2026.
But encouraging inflation readings released since the June Fed meeting have many expecting multiple rate cuts this year. According to CME Group's FedWatch Tool, futures traders are pricing in majority odds at of at least two quarter-point rate cuts by year's end, the first of which is expected to occur at the next Fed meeting.
So how should investors prepare?
For starters, no one should make dramatic short-term moves with their portfolio based on modest changes in interest rate policies. If you're investing via a diversified portfolio with an eye toward the long term, it isn't necessary to make significant changes just because the Fed's policy approach is evolving.
But if you do decide to make adjustments, there are certain areas and sectors of the market that historically perform better in lower-rate environments.
For instance, a lower federal funds rate will generally stimulate growth overall for the U.S. economy. When borrowing costs decline, big-ticket expenses can be more palatable to both consumers and businesses.
This decline in borrowing costs can have a positive effect on growth stocks, as it reduces the amount of interest companies are paying on loans and increases future earnings estimates. Investors seeking out high-quality growth stocks want to home in on the technology and communication services sectors.
The real estate sector also benefits from lower borrowing costs. "REITs [real estate investment trusts] often rely on debt to finance acquisitions, develop projects, and finance other capital expenditures," explains Crystal Capital Partners. "When interest rates rise, the cost of borrowing increases, leading to higher interest expenses for REITs. This can squeeze profit margins and reduce the funds available for distribution to shareholders."
But lower borrowing costs "enhance profitability" and boost cash flow which real estate investment trusts can use toward reinvestment and shareholder-friendly initiatives like dividends, the alternative investment platform says.
Small-cap stocks are another asset class that tends to do well when interest rates are lower. Indeed, the Russell 2000 Index, which is a proxy for small caps, has vastly underperformed its larger-cap counterparts in recent years – up roughly 122% on a total return basis (price change plus dividends) since March 2022 vs the S&P 500's 163% rise.
"Small caps are typically more sensitive to interest rates than larger-cap firms since these smaller firms use more external financing for growth," says Jeffery Roach, chief economist at LPL Financial. However, while Roach says "falling interest rates will help small caps," he warns that investors must balance this with the fact that they also often "feel the impact of a slowing economy."
Investors can also gain exposure to this space with small-cap ETFs, which spread the risk across a basket of stocks.
It should go without saying, however, that rates are just one part of the equation for investors. There are plenty of boom times that occur when interest rates are high and even rock-bottom rates haven't been unable to offset periods of economic crisis.
As such, folks should always take a holistic view of their portfolio – and the economy in general – before making any major changes to their investment strategy.
