How do rate cuts affect my investments?

The U.S. Federal Reserve will lower interest rates by 25 basis points at its next meeting in September. Or that, at least, is the consensus of the markets. According to the FedWatch tool from CMEGroup, the likelihood that the Fed will reduce the official range from 4.25-4.50% to 4.00-4.25% is around 90%.

In recent weeks, these rumors have strengthened to almost become certain, due to some weaker economic data. The level of job creation observed during those months implies a slowdown in economic growth, so a rate cut may be key to stimulating the economy. Moreover, inflation has continued on its downward path and is getting closer to reaching the 2% target (currently, after the July data, it stands at 2.7%) set by the Federal Open Market Committee (FOMC).

At this point, what investors are interested in knowing is how their portfolios would be affected if this rate cut were to take place.

“Old” bonds rise in price (but the “new” ones pay less)

When focusing on fixed income, as interest rates fall, older bonds with higher coupons become more valuable. For example, if you bought bonds at 5% and then rates drop to 3%, your 5% bond becomes more attractive and is worth more. When interest rates decrease, several things happen simultaneously with the bonds:

• The price of existing bonds rises: as rates decrease, bonds that already existed previously rise in value. This positively drives the profitability of the funds that contain them.
• Yields on new issues fall: newly issued bonds will pay less interest. In other words, if you buy a bond now, you will earn less future interest. This reduces the potential long-term return of new bonds.
• Movements toward higher returns: the reduction in rates motivates many investors to seek other alternatives to obtain higher returns. This may lead conservative investors to move to higher-risk assets.

More cheap credit... but beware of bubbles

Regarding equities, a rate cut tends to create a positive environment in the stock market for several reasons:

• Easier access to credit: when central banks lower the rates, companies and consumers pay less interest on their loans. This leaves more money available to invest in business growth and to spend on consumption, two drivers of corporate profits. At this point, companies in sectors that are more dependent on debt usually benefit the most. For example, the real estate sector or discretionary consumption.
• Search for returns: with low rates, bonds and deposits yield much less. Many investors turn to stocks seeking higher returns.

Overall, as we have seen, falling interest rates often drive equity markets. However, there are also risks. If credit expansion is not carried out properly, the prices of some stocks could rise too quickly, boosting demand and creating what is known as asset “bubbles,” and therefore inflationary pressures.

In addition, there is a risk of reversal—that is, if the economy worsens and central banks are forced to change course (for example, not cutting or even raising rates again), the most indebted or highly valued stocks could fall sharply.

Ultimately, rate cuts are one of the most influential levers of monetary policy, as they can stimulate the economy by encouraging household spending, facilitating business investment, and increasing the value of financial assets, among other things. However, it also fosters a greater level of indebtedness and can fuel bubbles in certain markets. 

Always work with a financial expert

It is key to remember that these effects depend on the economic data and the Fed's own decision. As we mentioned at the beginning of this article, the market is almost certain of a cut in September, but changes in employment or inflation could alter that outlook. Therefore, investors must maintain a diversified strategy, tailored to their risk profile, and have a clear investment horizon.

For all the above reasons, it is always very helpful to have a good finance professional to guide us and help us get the most out of our investments. At MAPFRE, we have a team of financial experts, MAPFRE Gestión Patrimonial, who help investors find the options that best suit their objectives and needs.