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Interest rate cuts have been at the forefront of financial conversations this year.
The Federal Reserve raised interest rates from nearly 0% to over 5% from 2022 to 2023 to help curb high inflation due to excessive spending.
The Fed is finally starting to cut rates as it grapples with still-sticky inflation amid a struggling economy with a poor job market.
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These most recent cuts were anticipated, and the Fed hopes they’ll make it easier for Americans to borrow money, boost the economy and increase job opportunities.
Interest rate cuts will affect your financial picture, but the impacts might be different from what you expect and might not be felt immediately.
It’s important to understand the exact impact and how to help position your money for success.
Borrowing rates vs interest rates
When the Fed raised interest rates to slow excessive spending after the pandemic, borrowing rates skyrocketed, with mortgage rates reaching their highest levels since 2000.
Even though these rates have fallen slightly in the past year, borrowing rates for mortgages and cars remain high, which has led to a slower housing market.
While consumers welcome rate cuts, they won’t have a direct impact on borrowing yet. These rates aren’t directly tied to the Federal Reserve cuts, and mortgage rates increased from 6.31% to 7.05% during last year’s interest rate cuts.
These rates are more closely tied to the treasury index, which tracks several recent treasury auctions of U.S. Treasury bills, including five- and 10-year notes.
Mortgage rates have slowly fallen to a three-year low after October’s rate cut, while car loan rates have ticked up. If you hope they drop further, your wait might take longer than expected.
Timing the market is challenging. What’s more important is having a solid borrowing plan in place that doesn’t rely on market changes to make your housing options affordable.
Stock market returns
Historically, lower interest rates incentivize consumers and companies to spend more, which boosts the stock market.
The New York Times found that in the last seven instances since 1976 in which the Fed reduced interest rates after a six-month pause, the S&P 500 grew an average of 15.5%, above the overall average annual growth of 10.1% across the same period.
Expand that to rate cuts that occur when the S&P 500 is near record highs, and the average return over the following 12 months is 13%.
In the 12 months following last October’s 25 basis points rate cut, the S&P 500 jumped over 15%.
This doesn’t guarantee that we’ll continue to see these gains in the next year, but it’s likely to bode well for our investments.
Bonds also have an inverse relationship to interest rates. The interest rate on a bond is typically fixed throughout the life of the bond, so if the Fed drops rates, your bond’s rate will remain higher, therefore more valuable relative to the market.
If we anticipate rates will continue to fall, the current bond market could become an option to reposition your money.
High-yield savings, CDs and money market accounts
Money market accounts, high-yield savings accounts and certificates of deposit (CDs) have become attractive during this period of high interest. Average returns rose in tandem with interest rates, reaching as high as 5% by the end of 2023.
If interest rates continue to fall, expect returns to continue dropping, as well.
While these accounts are safer in nature and have the ability to provide a steady return, lower interest rates mean you might want to adjust your portfolio. That could mean investing more aggressively through private equity or alternative investments.
Each investor has their own risk tolerance and might not want to invest as aggressively. In those cases, other options could include investing in dividend-focused stocks to use the dividends for income.
Interest rate cuts are an important economic factor to monitor, and they’re a reminder of the importance of adjusting your financial plan on a regular basis. These changes likely won’t be felt immediately, but you should include them in your long-term plans.
Consider consulting a financial adviser to help you understand how this will affect your financial plan and what moves will be right for your unique situation.
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.