The Federal Reserve has sent clear signals: The era of interest rate hikes begun in March 2022 is over and rates are on hold – for now. Investors are now reading the Fed tea leaves to see when it will begin to move in the opposite direction and cut rates. Although those cuts could still be months away, investors may want to consider if their portfolios are positioned for a new rate regime, or if adjustments should be made. Indeed, historical market analysis shows the time to adjust portfolios is in the months leading up to a rate cut, not just after one occurs.
The Coming Regime Shift?
The Federal Funds Rate is at its highest level since 2001. The Fed began raising it in March 2022 to bring down high inflation and with the goal of engineering a “soft landing” of the economy, where growth slows, but the economy does not slip into a recession. So far, they appear to have succeeded in their efforts. The economy has shown remarkable resilience and inflation is generally lower, albeit with some exceptions.
Why then, would the Fed consider cutting rates? There are basically two main reasons:
- First, the Fed is likely to cut if inflation has fallen into the target zone of 2%. Fed Chairman Jerome Powell made it clear at his press conference following the January meeting that the Fed “wants to see more data” before cutting rates; in other words, adopting a wait-and-see approach.
- Second, the Fed may cut rates in the hopes of jump-starting a slowing economy. Clear indications of a rapidly contracting economy, such as weak employment figures or other signs pointing toward a recession, may prompt the Fed to lower rates to prevent an economic downturn.
Either way, the Fed tried to be very communicative around rate hikes and it is likely they will do the same around cuts. From what they are indicating, although timing is uncertain, rate cuts are likely to begin at some point in the not-too-distant future.
Implications: What History Tells Us
In general, what investors consider higher quality assets – for example, U.S. Treasuries, the classic safe haven during economic turmoil, as well as value stocks, considered to be more stable companies --perform best in the periods leading up to and following a rate hike. As the chart below demonstrates, those asset classes outperform their competitors in the three months leading up to, and following, a rate hike. Notably, most of this outperformance occurs before the initial rate cut, as investors begin to respond to expectations of lower rates. Investment grade bonds also perform well, which are similarly considered more stable.
Over a slightly longer time frame of six months before and six months after the first rate cut, the performance differences become even more pronounced. Historically, as the chart below shows, 10-year U.S. Treasuries have returned nearly 16% over that period, while value stocks and investment grade bonds rose roughly 10%.
To be sure, no one can guarantee what happened in the past will reoccur. However, there’s an old saying that history doesn’t repeat itself, but it often rhymes. In the past, when the signals were flashing that a rate cut is coming, investors responded by repositioning their portfolios. It may well be time to consider similar steps.