Cutting Rates, Cutting Returns: The Impact of Fed Policy on Asset Classes

The Federal Reserve has declared its intention to cut interest rates three times this year, barring a significant rise in inflation, which occurred in March. As we potentially approach a peak in rates and several cuts in the near future, it is useful to examine what has happened historically to major markets after the Fed started lowering rates. Analyzing data from 1970 to the present, we identified approximately 11 US business cycles where rates peaked and the Fed Funds Rate moved lower in the subsequent months and years.

Lower interest rates should positively impact traditional asset classes like stocks and bonds. For stocks, the primary benefit of lower rates is a decreased cost of doing business: firms pay less to borrow money, allowing profit margins to expand. In other words, the discount rate for future dividends and earnings decreases. Corporations also experience secondary and tertiary benefits, as lower rates typically boost overall economic growth and consumer demand, increasing firms' revenues. For fixed income holders, the relationship between lower rates and prices is even more direct. When yields fall, bond prices rise, and bond yields are equivalent to a continuous series of present and future short-term rates compounded together, so lowering short-term rates is typically reflected across the yield curve.

The results of our analysis of different asset classes after initial rate cuts are shown below, and in some cases, the numbers are quite surprising. Our baseline for performance is the first or top row in the table, which displays each Index's average annual percentage change over its entire history, effectively representing the normal performance of each asset class. The second row indicates the average 1-year percentage change over the 11 instances after rates started falling. As you can see, most assets actually underperform their long-term averages over the next year when the Fed begins cutting rates.

More specifically, equities produced returns that were quite poor and significantly below their historical norms, albeit with positive and negative extremes. In the case of small caps, the returns were actually negative, which is quite shocking and counterintuitive. The other losers were Gold and the US Dollar. Lower rates typically drive fund flows out of the currency with falling rates into currencies with higher rates, so the modest decline in the Dollar makes sense. The behavior of Gold is harder to explain, as many people view Gold as a safe haven when the US Dollar falls. In contrast, bonds really outperformed, as one would expect. Oil, on the other hand, seems to be the asset least impacted by lower rates, with returns quite close to its longer-term average.

Since business cycles, rate cuts, and their effects typically last for several years, we wanted to see what happens to performance over the next 3 and 5 years after the first rate cut. In other words, does the underperformance of stocks and outperformance of bonds persist? In fact, it does. The next two tables show that the longer-term weakness in equities continues, especially for the Russell 2000. Five years out, both the S&P 500 and the Nasdaq Composite are positive but about 75% below their long-term averages. Meanwhile, bonds perform extremely well. Fixed Income outperforms every other asset in our table except the Nasdaq, including the S&P 500, providing further proof that diversification matters. Looking at other indexes, the US Dollar's underperformance persists as lower rates make it less attractive, while Gold reverts to its longer-term average return. Interestingly, oil performs very well, perhaps as a result of strong demand from economic recovery.

We caution against drawing strong conclusions from the tables above, given the limited sample size of eleven instances and the range of positive and negative outcomes around the average. Nevertheless, the results confirm some expected outcomes, such as bonds performing well when the Fed starts cutting rates, and raise questions about why equities underperform when they should be expected to do better than average.

Our best guess regarding equities is that by the time the Fed starts cutting rates significantly, a lot of optimism, perhaps too much, has already been priced into stocks. The last table below shows the performance of each asset in the three years leading up to the first rate cut compared to the 3-year average or normal percentage change for the same asset over its full history. As you can see, stocks, Gold, and the US Dollar strongly outperform their long-term average in the three years before the first rate cut.

To summarize, Fed rate cuts produce predictably strong performance for Fixed Income but seem to function almost like a performance anchor for other asset classes. Stocks, Gold, and the Dollar typically outperform leading up to a rate cut but then revert below their mean, underperforming in the 1-5 year period after the cut. Given the recent significant run-up in stocks and assuming the above analysis holds true with an expected rate cut this year, bonds currently appear to be a beneficial diversifier going forward.

Data Source: Bloomberg

Make the most of these insights using Modelist. We create customized investment models for the fiduciary financial advisor. Get in touch with us at hello@modelist.me for a personal consultation.

Modelist Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.