Strategies for Financial Investments Amidst Anticipated Federal Reserve's Decrease in Interest Rates
In a recent meeting on July 29-30, the Federal Reserve opted not to make any major moves, keeping the federal funds rate steady at 4.25% to 4.50%. However, the odds of a rate cut in September dropped below 50% following this decision.
In a falling-interest-rate environment, growth stocks, particularly tech, small-caps, and other companies dependent on expectations of future earnings, tend to benefit most. This is because lower rates reduce their cost of capital and increase the present value of their future earnings, resulting in higher valuations and a potential "tailwind" to stock performance.
Bonds, on the other hand, when interest rates fall, existing bonds with higher coupons become more valuable, causing bond prices to rise. However, new bonds will offer lower yields, making saving through bonds less attractive. Bond investors may see gains in price but lower future yields.
Savings accounts, money market funds, and Treasury bills may offer slightly lower yields as a result of lower rates. The prime rate, which is closely tied to the fed funds rate, will also be affected.
Lower interest rates stimulate economic growth, which boosts corporate earnings. As a result, stocks may become more attractive relative to fixed-income alternatives as rates fall. This is good news for the stock market, with a more accommodative Fed generally being good for market performance.
Tech stocks and small-cap stocks, as well as other high-growth sectors, may get a tailwind when the Fed starts cutting interest rates again. This is because these companies often depend heavily on external financing and long-term earnings prospects.
However, it's important to note that the financial sector, such as banks, may face headwinds because their net interest margins compress when rates decline, potentially reducing profitability.
Looking ahead, the target range for the fed funds rate is likely to be lowered by the end of the year. An unexpected uptick in inflation could cause Fed Chair Jerome Powell to delay lowering interest rates. Longer-term bonds, with maturities of 10 years to 30 years, may become marginally more attractive, potentially offering higher yields.
Valuation math favors growth in a falling-interest-rate environment, as lower interest rates increase the present value of future profits. Following the July jobs report, the odds of interest rates being lower after the next Fed meeting jumped to 80.8%. As of July 30, the CME Group's FedWatch tool showed a 41.3% chance of a 25 basis points rate cut.
In summary, lower interest rates increase bond prices and reduce savings yields, generally boost stock markets with particular gains for tech and small-caps, while potentially squeezing bank profits. As we move forward, it will be interesting to see how these trends unfold in the coming months.
Investors may find tech and small-cap stocks more attractive as lower interest rates can increase the present value of their future earnings, providing a potential boost to stock performance (investing). On the other hand, the financial sector, such as banks, may face challenges due to a compression of net interest margins, which could potentially reduce their profitability (finance).
