How Do Investments Perform When The Fed Starts Cutting Rates?

March 20, 2024

In the 12 months after the US Federal Reserve (Fed) has started cutting interest rates, the average real return for US stocks (i.e., the average return for stocks after adjusting for inflation) has been 11%. US stocks outperformed government bonds by 6% and corporate bonds by 5%, on average.

Cash has been left further behind: On average, stocks have beaten cash by 9% in the 12 months after rate cuts start, while bonds have also outperformed cash (FIGURE 1).

As of 12/23. Past performance does not guarantee future results. Indices are unmanaged and not available for direct investment. See below for representative index definitions. * Indicates that a recession occurred within 12 months. Return Data Sources: CFA Institute, SBBI database, and Schroders. Fed Funds Data Sources (1928-1954): New York Tribune and The Wall Street Journal via FRED in which a 7-day average has been taken to remove daily volatility, an approach consistent with the methodology of the St. Louis Fed. Fed Funds Data Source (1955-2023): FRED.

Stocks Prefer If A Recession Can Be Avoided

These returns are even more impressive considering that in 16 of the 22 cycles, the US economy was either already in a recession when cuts commenced or entered one within 12 months (FIGURE 2). Stock returns were better if a recession was avoided and even if it wasn’t, they were still positive on average.

As of 12/23. Dots represent the beginning of a rate-hiking cycle; shaded areas represent recessions. Fed Funds Data Sources (1928-1954): New York Tribune and The Wall Street Journal via FRED in which a 7-day average has been taken to remove daily volatility, an approach consistent with the methodology of the St. Louis Fed. Fed Funds Data Source (1955-2023): FRED.

While recessions aren't desirable, they haven't always been something for investors to fear. By contrast, bond investors tend to do better if a recession occurs. They have historically benefited from safe-haven buying (especially government bonds), which drives yields lower and bond prices higher. They’ve also done ok if a recession was avoided. In this scenario, corporate bonds have, on average, outperformed government bonds.

The range of historical returns is wide for stocks and bonds, and both have tended to do well when the Fed has started cutting rates.

What About Today?

Unlike most historical episodes, the Fed isn’t considering cutting rates because the economy is too weak. Instead, it’s doing so because inflation is heading in the right direction, and policy no longer needs to be so restrictive. If the Fed is right and able to engineer a soft landing, then 2024 could be a good year for both stock and bond investors alike.

If you have specific questions or would like to discuss your own investment strategy or financial planning needs, we welcome you to call us at 302.234.5655 or email us at contactus@covenantwealthstrategies.com to set-up a time to discuss further.

Disclosures:

All investing involves risk, including loss of principal. Indexes are not investments, do not incur fee and expenses and are not professionally managed. It is not possible to invest directly in an index.

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax situation with a qualified tax advisor. The charts above are for illustrative purposes only.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Cash is represented by Ibbotson SBBI US Treasury Bills, which analyzes the performance of a single issue of outstanding US Treasury bills with a maturity term of around 30 days.

Corporate Bonds are represented by the Ibbotson SBBI US Long-term Corporate Bonds Total Return, which analyzes the performance of a single issue with a maturity term of around 20 years.

The federal funds rate is the target interest rate set by the Federal Open Market Committee. This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.

Government Bonds are represented by the Ibbotson SBBI US Long-term Government Bonds Total Return, which analyzes the performance of a single issue of outstanding US Treasury bonds with a maturity term of around 20 years.

Real returns are the annual percentage of profit earned on an investment, adjusted for inflation.

US Stock Market is represented by the S&P 500 Index, which is is a market capitalization-weighted price index composed of 500 widely held common stocks.

Important Risks: Investing involves risk, including the possible loss of principal. Fixed-income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall.

US Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest.