What 96 years of interest rate cuts tells us about where to invest

With everyone expecting that the Federal Reserve will cut interest rates this year (and probably more than once), it could be helpful to know what that might mean for your stocks and bonds. Conveniently, the folks at UK investment group Schroders have checked out the history – studying 22 rate-cutting periods, dating all the way back to 1928. They say that if the prevailing trends hold, you could expect to see a good year for bonds – and an even better one for stocks.

So what were the findings?

Schroders’s researchers found that, historically, in the 12 months after the Federal Reserve (the Fed) began cutting interest rates, US stocks saw an average return that was 11 percentage points higher than inflation, six percentage points higher than government bonds, and five percentage points higher than corporate bonds.

Stocks also beat cash returns in those periods by nine percentage points, on average. And that means bonds were also a better place to be than cash in those times.

The research is particularly relevant today, with the Fed expected to begin rate reductions in the spring and dropping hints that there could be three cuts in store this year.

Falling interest rates increase the valuations put on stocks and bonds, as the “risk-free” rate delivered by government debt falls when interest rates drop, making riskier assets (like stocks) more attractive.

What does it all mean?

Well, it bodes pretty well. As Duncan Lamont, Schroders’s head of strategic research, noted, those historical returns are even more impressive when you consider the economic backdrop: in 16 of the 22 cases studied, the US was either already in a recession when the cuts began or slipped into one within a year.

And, sure, stock returns were better in scenarios where the economy managed to avoid a recession, but they were still positive, on average, even when it didn’t.

There were some big, notable exceptions to the rule, of course. But overall, Lamont says, while no one ever wants a recession, stock investors probably don’t have to be terrified of one either.

Bond investors, meanwhile, generally tend to do better in a recession. Bonds – especially government bonds – benefit from the subsequent rise in safe-haven buying that happens in a downturn. That buying drives their prices higher and their yields lower. But bonds have also historically done okay when the economy has swerved and missed a recession.

Now, the Fed, of course, adjusts interest rates with its dual economic mandate in mind: achieving price stability and maximum employment. So usually when these central bankers are considering cutting interest rates it’s because the economy’s on rocky ground, and the job market has taken a tumble and thrown millions of people out of work. This time around, however, it’s a different story. They’re aiming to make cuts because all those aggressive interest rate hikes from the past two years have mostly finished their job – bringing inflation to heel – and those elevated borrowing rates won’t likely be needed for much longer.

If they’re right, and the Fed can engineer a “soft landing”, bringing inflation back to its 2% target without triggering a recession, then 2024 could be a good year for stock and bond investors.

Stock markets have started the year well. The S&P 500 index of America’s biggest shares has risen about 4% so far this year, and the MSCI World index is up 5.25%. Meanwhile, global government bonds have fallen about 1%.

US shares make up about 70% of the MSCI World index, which is one of the more popular core allocations and is available through global tracker funds such as the Fidelity Index World, the HSBC MSCI World ETF, or the iShares Core MSCI World ETF.

Investors can also take a more targeted approach to US shares, locking in exposure to the S&P 500 with trackers like the iShares Core S&P 500 ETF or the Vanguard S&P 500 ETF. Both funds regularly appear on ii’s list of most-bought ETFs and both charge 0.07% a year in fees.

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