Investing and Interest Rates: What You Might Expect When the Fed "Pivots"

Since you've been watching the headlines more and more now that your a Saver and Investor and don't want to get ambushed by any crazy economic or financial news, you've no doubt picked up on how obsessed everyone is with interest rates. In this case what we're actually talking about is the Federal Funds Rate, which is sort of the lowest interest rate you can get anywhere. It's the rate that banks have to pay the federal government to borrow money: everyone who then borrows from a bank has to pay that amount plus a little bit more so that the banks can also make profits.

This baseline interest rate that is charged to borrow money is also called the "cost of capital." That means if you need money ("capital") to invest in something (stocks, crypto, real estate), you have to pay a cost to get it, which is the interest rate. So it goes to reason that everyone watches what Federal Reserve Chairman Jerome Powell and the Federal Open Market Committee (FOMC) say and do, because they really need to know if it's going to be more expensive or cheaper to borrow money -- and if their investments and money they lend out will bring in higher or lower returns.

If you know something will be cheaper next month, what would you do? Would you buy it now, or wait? What if you thought it would get more expensive? You'd probably buy now as much as you can -- then you'd switch to buying something else cheaper later. Investing and financial markets end up following the same basic pattern, so it's important to have a general idea of what to expect when interest rates rise or fall. Of course every case is different, but with a little knowledge you can be pretty smart about your investments.

On Friday, August 23rd Jerome Powell said "the time has come" for cutting the Federal Funds Rate, so it's officially time to pay attention and not just guess like the media do.

Interest Rates and Investing 

A crucial thing to understand is that when it comes to interest rates the biggest impact in terms of your personal finances isn't on how much you'll pay for a loan. Instead it's how much your savings and investments will make in profit compared to before. All the money you have saved in your bank accounts is used by banks to lend to others. When interest rates fall, the interest you'll earn on your savings -- including your High Yield Savings Account, CDs, and Money Market Funds -- falls with it. That means you will make less money with your saved cash. So, too, do the big bank, institutional investors, hedge funds, pension funds, and more.

Money needs to move into "riskier" assets like stocks and crypto in order to keep earning high enough returns to meet investment goals. This is one reason why investors get excited when interest rates go down: more money flowing into the stock market and housing market will make the values of their assets go up. They get richer. What this means is knowing if and when to shift; what it does not mean is to panic sell or panic buy and do whatever it is you see other folks in your unit doing when things start to change.

For example, as headlines start talking about the "r" word (Recession), I bet you more than one senior enlisted or officer in your unit has talked about shifting their TSP from the C Fund (which invests in the S&P 500) to the F Fund or G Fund (TSP's bond funds). But is that right? Let's take a look.

The Economy Versus Financial Markets

In our August 7th post, "Keep Calm and Invest On," we discussed how it's not the headlines that actually matter when it comes to recessions or crashes. The big picture of the economy matters more. The same understanding needs to be applied to forecasting the effects of interest rate changes on your investments, whether they be stocks or real estate or crypto or something else. The reason for that is a fairly simple "binary", or two-way, relationship between interest rates and the economy (and financial markets).

At the beginning of this article, you learned that interest rates change the cost to borrow money and the returns you get on your investments. Since right now in 2024 we're talking about interest rates going down, the expected result is that cash investments will be less profitable so a lot of money will get channelled into stocks and real estate. The stock market and home values should go up, and if you have invested in those types of things, you'll get richer. This is the first and most logical effect of interest rate changes.

The second is a bit different, in that it is illogical: it produces the opposite effect. Interest rates fall -- but also stocks, crypto, and real estate fall with it. Why would that happen? That happens when the Federal Reserve cuts interest rates in reaction to a recession or economic crisis. And what it means is that the economic crisis or recession was and will be more powerful than any changes in the interest rate.

In other words, the mere fact that interest rates are going down doesn't really tell you much of anything about what will happen. You need to know the ground truth about what's happening in the economy. This is why it's so important to not get tangled in the headlines, and to grow your FiIQ so that you can avoid making an emotional reaction -- and so you are "careful to not step in the bulls#!t."

Impact of Falling Interest Rates on Different Asset Classes

First let's make sure we understand what various investments should do in normal times:

1. Cash (HYSA, CDs, Money Market Funds, etc.). The Annual Percentage Yield (APY), or the interest you earn, goes down, too. (So long as you are holding cash in an HYSA it will most likely stay ahead of inflation, which is more important than profits for your Emergency Savings Fund (ESF), etc.)
2. Bonds (including Treasuries, aka T-Bills). Lower rates equals lower yields, so bond holders (people who buy bonds to collect interest as income) will earn less profit or income. On the other hand lower yields means higher prices for the bonds, so the returns should go up for bond investors (people who own things like bond mutual funds such as the TSP's F Fund or G Fund).
3. Stocks. Lower interest rates make money easier to get to buy stocks, so stock prices go up.
4. Real Estate. See #3.
5. Cryptocurrency (Bitcoin). See #3.

Problems arise, however, when the economy is in trouble. Again, we're not talking about what the headlines predict might happen, but what is actually going on. In that case, as you've just read, the interest rates are cut as an attempt to stop or slow down a Recession. When the economy is going down, about the only thing you can know for certain is that the price of bonds, and therefore the value of bond mutual funds, is the one asset class that will go up. Everything else is most likely going down with the ship.

History as Our Guide

As it is the underlying state of the economy that determines the effect of lowered interest rates, let's take a look at four examples from our lifetime of the Federal Reserve lowering interest rates:

• January 2001. The Dot-Com Bubble had burst and the economy and stock markets were in free-fall, so the Fed cut rates to try and "rescue" the economy. This was a reactionary cut .
• August 2008. The 2008 Financial Crisis had struck, the Housing Bubble had burst, and the country was descending into the two-years-long Great Recession. This, too, was a reactionary cut.
• August 2019. The Federal Reserve was worried about an economic slowdown caused by the US-China Trade War, and lowered interest rates as a stimulus. This was a  preemptive strike cut.
• March 2020. After a 3-day slide in global stock markets in reaction to the COVID-19 outbreak, the Fed cut rates to reassure investors and stimulate the economy. This was also a preemptive strike cut.

This gives us two events for each of the two combinations of the economy and falling rates: reactionary cuts to "rescue" the economy from a recession in 2001 and 2008, and "preemptive strikes" in 2019 and 2020 to fend off a possible recession. In August 2024, despite rising unemployment and falling manufacturing output, the overall U.S. economy and job market continue to grow, and inflation continues to fall. By all traditional measures, we are NOT in a recession right now.

This suggests the rate cuts we expect to see from the Fed will be more likely to follow the patters of 2019 and 2020 as "preemptive strike" cuts. Jerome Powell has been the Federal Reserve Chairman since 2018, so you can bet that he feels pretty confident in that as well, which is why he is not waiting around for inflation to actually get to 2% (or for a recession to actually start).

Investment Returns in a Rate-Cut Cycle

Now that we've meshed together interest rates and the economy to get a decent idea of the current situation, let's look at the returns to investments in our favorite asset classes for the two different sets of conditions. We'll look at the S&P 500 for stocks, the U.S. Aggregate Bond Index for bonds, and Vanguard's VNQ Real Estate Exchange-Traded Fund (ETF) for housing. (Unfortunately Bitcoin was launched in January 2009 so we don't have a good picture of what it does when rates are cut during an established recession.)

First the "reactionary cuts" of 2001 and 2008, when the economy was already in trouble:

Next the "preemptive strikes" of 2019 and 2020:

History is fun -- I mean it! When you can get your head out of the social media hype and journalistic headlines and take a look back over time, you can see some patterns and start to make sense for the crazy, unpredictable future. In this case, you can, from within your lifetime, conclude the following:

1. Reactionary cuts in a recession aren't going to save the economy or the stock market;
2. Reactionary cuts help boost bond fund returns because all the big money was already going there anyway, and the rate cuts just increase the profits even further;
3. Once the recession ends, however, stocks and real estate catch back up to bonds fairly quickly;
4. Preemptive rate cuts tend to stimulate stocks and real estate, but leave bonds in the dust.

I'm not going to say anything about Bitcoin and cryptocurrency, because we never got the chance to see how it handles rate cuts during a serious recession. My guess is it will go the same way as stocks do -- but I challenge you to make your own conclusions about that!

Strategies for Your Investments in 2024

The U.S. economy is not in a recession, even if some measures are pretty clear that we could be heading there, and so the rate cuts coming in the last four months of 2024 are "preemptive strikes". They're meant to juice the economy, stock markets, and housing prices (and probably Bitcoin and crypto, too). If you move your TSP into the F Fund and G Fund, or sell VTSAX or other stocks in your brokerage and buy bonds, the most likely result is that you'll strangle your portfolio and end up with single-digit returns; those who stay consistent to their strategy and continue to invest in stocks and real estate are not being unrealistic in hoping for 10%, 30%, 40% or more returns over the next 1-3 years.

Of course that could all change if a recession occurs in 2025 or 2026 -- but why would you make decisions in 2024 with your money based on things that only could happen in the future?

Words of Caution

While the cautious investor who tries to predict market downturns always ends up losing out to those who stay consistent to their strategy, wary investors can find themselves being even more profitable. That means that you need to continue to watch the headlines and pay attention to your investments even as they're soaring higher.

The main risk of a "preemptive strike" by the Federal Reserve is that it juices the stock market and real estate too much and creates another "bubble." There was no doubt that the late-90s monetary policy fueled massive over-pricing of tech stocks, and that led to a massive crash. You should be cautious about that happening again in 2025 and 2026, especially given the rather massive run-up in AI stock prices.

It's also worthwhile heeding Warren Buffet's advice that "risky investments" are ones that you don't fully understand. All investments have risk, of course, but going out and investing in something you don't understand increases the risk of losing it all. Just because Bitcoin exploded in 2020 doesn't mean it will again: it's relatively new, widely hyped, and vulnerable to new government regulations. So whether you are considering investing in crypto, stocks, or real estate, take the time to study and learn what you're investing in before you move your life savings into it.

Finally, remember what you're saving for, and over what timeframe. For major purchases you'll make in the next 3-5 years, you don't want to put your cash at risk in the stock market where there's a chance to lose 1/3 or 1/2 of it. The same for your Emergency Savings Fund. Just because the APY, or return, on your HYSA will go down with lower interest rates, you should not be using that cash to chase higher returns. Keep it where it is, keep it safe -- and keep your financial security and dreams safe, too.

As you've seen in the long-run aftermath of reactive rate cuts in 2001 and 2008, the explosive growth of the stock market will eventually catch up and pass bonds, more than making up for any short-term losses. If you are in your 20s, 30s, or 40s, there's absolutely no need to try and move your retirement savings in the TSP from the C Fund to the F Fund, because in 20, 30, or 40 years you'll have more than made up for any short-term loss you had in 2025. On the other hand, if retirement is within the next 3-5 years, you may want to consider starting to get more "defensive" with your TSP investments.

  Conclusion

Understanding the impact of interest rate changes on different asset classes is crucial for making informed investment decisions -- but you must also pay attention to the broader economy first. Falling interest rates can create opportunities OR risks depending on what's happening in the bigger picture. Just because headlines predict a recession doesn't mean there will be one, and there's historically little or no benefit to trying to "time the market" and change your investments because of what you think might happen.

But no one can predict the future, so before moving around your investments between stocks, bonds, real estate, and even cryptocurrencies, take the time to study what's really going on. All investment comes with risk, and past returns do not guarantee future performance. Build your strategy, stay informed, and continue to build your FiIQ by studying investments with blogs, Podcasts, books, and other solid sources.