What It Will Look Like When Rates Drop
Thoughts for borrowers, savers, and investors
Last December, I wrote about the certainty that interest rates would drop in 2024. At the time, one of the key aggregators of Fed prognostication held a 100% likelihood that rates would ease by the Fed’s June meeting. In fact, the screenshot below is of a widely monitored Fed-watch tool as it read in December 2023, showing a 100% chance (!!!) of interest rate cuts by June, at least according to the so-called experts:
Spoiler alert: rates did not drop by June. So much for 100%. Instead, rates have remained higher for longer, as has been the industry parlance for much of the past year.
The Fed-watch tool noted above is now calling for a 70% chance that rates will drop by 25 basis points (i.e. 0.25%) at the upcoming September meeting. An inconclusive assessment? Well, not when you consider the other 30% likelihood per that Fed-watch tool is that rates drop by 50 basis points (i.e. 0.50%). The total odds of interest rate cuts whether it be 0.25% or 0.50% later this month are therefore, once again, 100%. This time they probably have it right, though.
As a quick aside, I cannot possibly imagine the Fed reducing rates by 0.50% after keeping them so high for so long. Not only is that in opposition to the hawkish philosophy on inflation of Fed Chair Jerome Powell, but it is against the overall Fed’s temperament. A significant interest rate cut like that could jolt the stock market in the wrong direction by injecting a dose of fear and panic. It would also be considered by many to be highly disruptive and potentially politically charged to drop rates by that much just prior to the election. So in my assessment, rates are not coming down this month by 0.50%, but I agree with the sentiment of certainty that rates are dropping by a quarter point when the Fed meets on September 18th.
Why are rates coming down? Inflation is finally leveling off, coming in at 2.9% in the July CPI report. The trajectory of inflation looks to be that it will cool further in the coming months. At the same time, the labor market is showing some slight cracks, with unemployment ticking up and the number of new jobs created coming in lower than expectations in each of the last several months. With inflation easing and the strong labor market showing signs of reversal, it is time to cut rates.
What it Means for Borrowers
For existing borrowers with a variable interest rate, as soon as interest rates drop, so too will their monthly loan payments. On new loans, there is a strong case to be made for variable debt at the moment, as there is more downside likelihood in rates than upside. The risk to the upside is, in theory, limitless, but the odds are much greater that one year, two years, and even three years from now or beyond, interest rates will be lower than they are today. So borrowers who are taking out variable loans will win as rates decline.
For existing borrowers with a high fixed rate, many will have hopes of refinancing to lower rates as they drop. The ability to do that will depend on their bank’s willingness to have that conversation. At the time of loan origination, borrowers (oftentimes in conjunction with their lender or bank management) decide whether to go with a fixed rate or variable rate. What borrowers want, of course, is the benefits of a fixed rate if rates were to rise, but the benefits of a variable rate when interest rates go down. On existing fixed-rate debt, banks will likely charge some sort of fee for the benefit of a rate reduction on a loan as rates start to decline. With that in mind, it may be worth it for borrowers to wait until rates drop even further before requesting a rate adjustment so as to avoid multiple closing costs on loan modifications or refinances if they want to refinance again when rates drop next, which could be as soon as November or December.
For would-be borrowers, lower rates are clearly good news. Whether borrowing to buy a home, a car, or for a business loan, the math just works better with a lower interest rate. Lower rates could spur increased borrowing activity, which has been sluggish for much of the past 12-18 months. The possible flip side is that as rates drop it could make things like the housing market even more competitive by drawing buyers back from the sidelines, although it could also boost inventory by also drawing out some sellers who have felt locked in with nowhere to go.
What it Means for Savers
Lower interest rates are not as good news for savers. For much of the past 20+ years, savers have earned anemic yields on checking, savings, and Money Market accounts. Since the Fed began its campaign of higher rates around the middle part of 2022, however, deposit rates have been notably higher. It has not been out of the ordinary to achieve 4.0-5.0%+ risk-free on various types of savings accounts including CDs and Money Markets. As interest rates decline, however, so too will yields on savings. Savers can expect to see their rates drop at about the same time and in proportion to the drop in interest rates on loans.
What it Means for Investors
For conservative savers and investors, the anticipated drop in yields would naturally spark the question about where to invest instead. More aggressive investors might similarly ask what the best investment strategy is in a falling interest rate environment.
With regard to the stock market, lower interest rates, in theory, should boost stocks as it reduces the cost of borrowing for businesses. Lower costs boosts profits, and the lower rates also could spur increased leverage for expansions, acquisitions, and investment in growth, all of which would lead to higher profits and stock appreciation.
Fidelity recently shared some data showing how the stock market typically outperforms in the 12 months following an interest rate cut. The chart below illustrates that in the 12 months prior to a first interest rate cut, if the economy has not been in recession, the stock market typically has achieved a 9.0% rate of return whereas in the 12 months following an interest rate cut, the stock market has performed at a 12.6% rate of return. The U.S. economy has not been in a recession at any point in the past 12 months, so that would be the relevant dataset here. The chart on the right also shows that when the economy has been in a recession, rates of return following interest rate cuts are even more robust.
The data above should be taken with a grain of salt, however. Not only does past performance not necessarily predict future results, but current stock market returns (and a lot of things in the overall economy) have been, for lack of a better term, weird ever since the pandemic. The S&P 500 was up a whopping 27% in the twelve months ending August 31st. I don’t necessarily think the pending interest rate cut is going to have a jolting effect in a positive direction for the stock market as the chart above would suggest, in part because the stock market has already been doing so well; it is not likely that the stock market outperforms 27% in the twelve months ahead of us.
Other than the stock market, other types of investments also will typically react in a positive or negative direction based on interest rate cuts. Bond prices, for example, typically rise when interest rates fall. The easiest way I have found to explain this is that if you have a bond that pays a coupon (i.e. interest) rate of 5.0%, but then interest rates fall to 4.0%, your existing 5.0% bond becomes that much more valuable, so its price increases. Conversely, if you have a 5.0% bond and interest rates increase to 6.0%, the 5.0% bond is not as valuable anymore because bond investors can get a new bond for 6.0%, so the price of the 5.0% bond falls. Many savers and investors do not typically think of bond prices as fluctuating all that much, but bond prices can and do change in a dynamic interest rate environment. Holders of bonds (and bond funds, for that matter), could see some increases in value as rates decline.
All usual disclaimers should apply here about how I am not a licensed investment advisor, and that you should consult with a financial planner and CPA before making investment decisions. The other caveat I offer to all of this is that investments do not typically react to things like interest rate cuts as if someone were flipping a light switch. Prices and anticipated fluctuations are baked in based on expected changes to the economy (including changes to interest rates) months in advance. One possible reason the stock market has been doing so well, for example, is that investors are anticipating these expected interest rate cuts, which they believe will be good for stocks. So rather than wait until the Fed meets on September 18th, they have been moving money around well in advance. This money movement in the stock market has led to strong gains for stock investors for the past year.
As another quick aside, the point above is also why bad news is often good news in the stock market. One might think that a bad jobs report would send the stock market down, but it is sometimes the reverse: a bad jobs report can actually send the stock market surging because weak economic data is sometimes interpreted as a domino that could lead to the Fed lowering interest rates, which would boost stocks as said cuts are realized.
What it Means for the Economy
It is easy to lose track in these conversations about why the Fed is actually set to lower rates: it is because there are concerns about the health of the economy. I will sometimes tell borrowers that lower interest rates sound good until you consider that they could also correspond with an economy that is struggling. What good is a lower interest rate to a restaurant or retail shop or hotel, for example, if it comes with a 5-10% reduction in sales due to a weaker economy?
The Fed’s goal, of course, is the so-called “smooth landing.” But even smooth landings sometimes feel hard, especially when the economy is coming off of the sugar high heights of the post-pandemic boom. I wish I could predict exactly where the economy (or the stock market, for that matter) will be in September 2025. I have a feeling that things will not be quite as stable as they are today. But time will tell. Investors should be mindful that the last couple of years have been particularly robust in the stock market and the pendulum does tend to swing, although if you’re saving/investing for the long haul it is still okay to take some risk and ride out those fluctuations. For borrowers, the months ahead should be a bit better than the months we have just gone through, tempered only by the overall systematic risk in the economy right now.
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com.