By Chuck Carroll, CFA, CAIA
Chief Investment Officer
TFO Family Office Partners
At its September 17-18 meeting, the Federal Reserve (“the Fed”) is expected to cut the federal funds rate. The Fed Funds rate is the interest rate at which banks make overnight loans to one another. It’s a tool used by the Fed to control the money supply in the U.S. economy and regulate the economy. A September rate cut has been talked about in the media for some time, with many outlets providing forecasts about what it will mean to the financial markets. Below we will discuss the elements of your financial world that you should expect to change if the Fed cuts rates, and others where a Fed rate cut will likely be less impactful.
Likely direct impacts of a Fed Funds rate cut
• Yields on money market funds, CDs and bank savings accounts will likely go down slightly. The yields on these accounts tend to be tightly correlated with the Fed Funds rate.
• Interest rates on adjustable-rate loans such as adjustable-rate mortgages, credit card debt, margin loans and new student loans will likely decrease slightly.
Impacts of a Fed cut that are less clear
• The short-term direction of bond yields and prices.
• The short-term direction of stock prices.
What about the bond market?
It’s important to remember that the Fed only controls the interest rate at which banks lend to one another. The Fed does not directly control the yields on intermediate-term bonds. Bond yields (and their prices) are driven by investors’ collective expectations about the future: Future inflation, future Fed actions, future risk tolerance of investors, etc.
To see how uncorrelated bond yields are from the actions of the Fed, all we have to do is look at the last 14+ months. The last time the Fed took any action was when it raised the Fed Funds rate on July 26, 2023. Since then, it has held the Fed Funds rate constant at 5.5%. But the yield of the 10-year Treasury bond has gyrated dramatically over that period, rising to almost 5% during the fall of 2023, then falling to its current mid-3% level.
Because bond yields are based on expectations, the chart above would seem to tell us that during the past 12 months investors have been incorporating their expectations of a future Fed rate cut into bond yields. As a result, Wednesday’s widely anticipated Fed rate cut is unlikely to have a direct impact on bond yields and prices.
What about the stock market?
In recent weeks, there seems to have been a flurry of media articles implying that a Fed rate cut will bring good things to the stock market. But history tells us that such a relationship isn’t as clear as the media would like us to believe.
Until the late 1980s, the Fed didn’t even use a Fed Funds rate target to set interest rate policy, instead focusing the level on nonborrowed reserves in the financial system and/or using open market operations (buying and selling of securities) to manage the U.S. economy1. Until 1994 the Fed didn’t even issue a “policy statement” describing its Fed Funds actions, much less hold press conferences to discuss its views of the economy and the rationale for its decisions2. The whole concept of “Fed watching” is only three decades old.
What can we tell from the past 30 years of transparent Fed actions? Since 1994, the Fed has cut the Fed Funds rate 30 times. Were those cuts signals that stock prices were going to rise? To answer that question, we looked at global stock market performance over the 12 months starting the 1St of the month after a Fed cut. The performance of the global stock market in the 12 months following those 30 cuts is shown below.
The chart above is likely to disappoint investors who want to believe that Fed actions influence near-term stock market performance. Stock market returns over the 12 months following a rate cut have covered an extremely wide range, from 55% in 2020 to -43% in 2008, and on average have been negative: -2.4%.
As we see in the chart above, rate cuts tend to come in bunches. What if we look at only the first rate cut in a cycle, like Wednesday’s cut would be?
There have only been five such “first cuts” in the past 30 years:
We see that “first” rate cuts have occurred in response to a variety of economic environments, and the performance of the global stock market following those cuts has also varied dramatically. To us, this is yet another piece of evidence that a Fed rate cut doesn’t mean near-term stock market gains (or losses) are a sure thing.
Summary
While a cut in the Fed Funds rate will likely result in lower yields on money market vehicles and lower debt costs on adjustable-rate debt, its potential impact on stock and bond prices isn’t clear.
If the markets do move dramatically on Wednesday (or at any time before or after), it will likely be because investors are digesting new, unexpected information. But trying to forecast what that latest information will be, and how investors will react to it, is incredibly difficult. As a result, we caution against making near-term predictions about the markets, and/or making specific decisions solely because the Fed’s actions. Rather, we encourage you to continue to have a long-term mindset and avoid letting Fed’s actions be a distraction to you.
As always, please feel free to connect with any member of your TFO team if you have questions.
