What does a US interest rate cut mean for investors?

10 Oct 24 6 min read

The Federal Reserve has kicked off a new era of interest rate cuts, signalling its confidence that the inflation fight is largely over. The central bank is now focusing on supporting the US labour market by reducing rates to a less restrictive level. During its most recent meeting on the 18th September, the Federal Reserve lowered US interest rates by 0.50%. But what does this mean for investors holding diversified multi-asset portfolios? Whilst the past is not always a guide to the future, we can still learn from previous periods when US interest rates were cut.

The returns of asset classes have varied in times when the Federal Reserve cut US interest rates. For example, US stocks rose 26% in the 12 months after the first rate cut in 1995 as the economy grew at a healthy rate. But during the dot-com bubble in the early 2000s, US stocks fell more than 11% in the 12 months following the first rate cut as the economy entered a recession.

12-month Returns of US Assets from the Date of the First Interest Rate Cut

Source: CFA Institute Stocks, Bonds, Bills and Inflation (SBBI®) database and M&G Wealth Investments. Total returns in USD. Fed Funds Data taken from Federal Reserve (FRED) website. Taken from past 7 times the Federal Reserve has cut interest rates. Recessionary periods indicate a recession occurred within 12-months after the Federal Reserve cut interest rates. 30th September 2024.

We looked at the 12-month returns for US stocks and US bonds from the date of the first rate cut during the last seven US interest rate cutting cycles by the Federal Reserve. We found that bonds tend to do well in an interest rate cutting scenario, whereas stocks produce mixed results.

This means for multi-asset portfolios, there is not a standard playbook for asset returns in the 12 months after the Federal Reserve cuts interest rates. But there is a clear difference in performance when we separate recession and non-recession periods. If the economy is heading for recession and the Federal Reserve cuts interest rates, it tends to be a bad time for multi-asset returns, especially for stocks as companies’ profits fall. If the Federal Reserve cuts rates without a recession, companies and households benefit from lower borrowing costs and growth stays positive. This is usually good for multi-asset returns with stocks outperforming bonds.

So what environment are we in today?

The key question is whether the US will fall into recession over the next year. When we look at the data, the US economy recently added 254,000 new jobs in September and the latest estimate of annualised US GDP Growth is 3.2% for Q3 20241. Typically, during recessions both of these numbers are negative suggesting we are a way off recessionary levels today. We must admit there is some concern when investors look at US unemployment, which has risen from a rate of 3.4% to 4.1%. But we think much of this rise is due to increased immigration meaning more workers are looking for jobs, rather than people losing their jobs. We think a US recession in the next twelve months is unlikely.

Given that the US economy is still healthy and expanding, we believe lower US interest rates are supportive for multi-asset portfolios. The past four times rates were cut and the US did not enter recession, US equity returns averaged 22% over the next twelve months while US bonds returned 8-9%.

How does cash compare?

Latest estimates indicate there is £430 billion in excess cash savings not invested by UK adults2. This level of cash savings can partly be explained by individuals receiving interest rates on their savings that they have not seen in 15 years. But what happens when central banks start to cut interest rates? We again looked at the past seven periods when rates were cut in the US to see how cash returns compared to other safe assets like US government bonds.

[1] Atlanta Fed GDP Now forecast, 10th October 2024.
[2] Barclays: The UK investment gap: £430 billion in cash savings not invested by UK adults, 11th September 2024.

12-month Returns of US Government Bonds vs Cash from the Date of the First Interest Rate Cut

Source: CFA Institute Stocks, Bonds, Bills and Inflation (SBBI®) database and M&G Wealth Investments. Total returns in USD. Fed Funds Data taken from Federal Reserve (FRED) website. Taken from past 7 times the Federal Reserve has cut interest rates. 30th September 2024.

We found that during the past seven periods when the Federal Reserve cut interest rates, government bonds on average did better than cash. One reason is that when interest rates fall, the return on your cash savings also falls. As investors see their cash returns fall, they look for other safe assets to invest in. This makes the fixed income payments of government bonds become more appealing. Investors will then move money from cash to bonds, which increases the price of bonds and the returns for bondholders.

Overall, we think bonds look more attractive than cash during periods when central banks cut rates. And if the global economy stays healthy and does not enter a recession as we expect, stocks should also perform well. We therefore think multi-asset portfolios are in a good position to benefit from central banks lowering interest rates over the near term.

And by the way, here’s what the past 5 calendar year returns look like for these asset classes: US Large Cap Stocks up 107.21%, US Government bonds down -4.89%, US Corporate Bonds up 11.77% and US Cash up 9.28%3.

[3] Source: CFA Institute Stocks, Bonds, Bills and Inflation (SBBI®) database and M&G Wealth Investments. Data shows 5-year returns to end December 2023. Total returns in USD.

Past performance is not a reliable indicator of future performance. The value of an investment can go down as well as up and your client may get back less than they’ve paid in.