What happens when FED (Federal Reserve, the central banking system of the USA) lowers interest rates?
Speculation about whether the FED will cut interest rates can generate a lot of happenings. It is not always clear how the cut might affect investors. So let us see how lowered interest rates can stimulate the economy and impact financial markets. Also let us take a look at which types of investments historically performed the best in low interest rate environments.
The goal of the federal reserve or the FED is to keep the US economy healthy two ways.
- Minimizing Unemployment
- Stabilizing Inflation
FED does this by decreasing or increasing interest rates. Historically as the economy has shown signs of weakness, the FED has responded by cutting interest rates.
Here is how it works.
A committee within the FED called the Federal Open Market Committee (FOMC) meets 8 times a year to look at the health of the economy. If there are signs of a weak economy, like rising unemployment and stagnating job growth, the FED may decide to lower interest rate, specifically, the federal funds rate. Generally, when the federal funds rate is low, the banks lower their interest rates. This can help stimulate economic growth in a couple of ways. First, lower interest rates makes it cheaper for people and businesses to borrow money for big purchases and 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 the virtuous cycle of spending and growth that creates jobs and steer inflation towards healthy levels. However, it is likely to be sometime after the FED cuts before consumers begin to feel the signs of economic growth. Though the economy responds slowly, you may see changes in stock and bond markets immediately. For major stock indices rate cuts are typically good news. All expectations are often priced in. Sometimes there is a surprise that can cause the market to spike. In fact, sometime just rumors in cuts can cause a rally. For example, in June 2019, FEDs chairman J. Powell assured that the FED will act as appropriate to sustain the expansion. Many investors interpreted this as a hint that the interest rate would be cut. As a result stocks soared and DOW broke a six weeks losing streak. Historically, the S&P 500 index has generally performed well following interest rate cuts. It 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. 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 at a higher price in the secondary market.
Over the past 46 years, the performance of stocks, commodities, REITs (Real Estate Investment Trusts) and gold was relatively balanced. But, during low interest rate environments, REITs and US stocks have been the highest overall performing asset classes. Because interest rates are typically cut during an 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 dividend as well. But remember, the point of cutting interest rate is to nudge the economy in the opposite direction. Though cuts may be the result of negative economic outlook, forward thinking investors may want to anticipate our interest rate cuts which may help spur along longterm economic growth.
Courtesy: TD Ameritrade