Falling Interest Rates

What Lower Interest Rates Mean to You and Your Portfolio

Why should you care about the federal funds rate—the rate at which Federal Reserve banks lend money to each other? Chances are it won't translate into a lower interest rate on your credit card—and it doesn't necessarily move the mortgage rate lower. However, it is a key indicator of where the nation's central bank expects the economy to be headed in the months ahead. The Federal Reserve Board typically lowers short-term interest rates when it wants to prod the economy back to life by making it cheaper for businesses to borrow money.

Over time, there has been a direct link between short-term interest rates and the direction of the stock market. History shows that one interest rate cut is rarely decisive. However, when the Fed cuts interest rates two or more times, it has often jump started a lackluster stock market down the road. Seventy-five percent of the times that the Fed has brought interest rates down in a series of cuts since the late 1960s, the stock market has been higher 12 months later—even when the economy has taken a dive.

The Economy Rises

Stocks tend to rally when interest rates come down because lower interest rates increase the flow of dollars into the American economy. Borrowing is cheaper. The cost of doing business, in general, goes down, which makes companies feel better about hiring new employees. And the stock market is typically forward looking: by the time the Federal Reserve Board has lowered interest rates several times, the economy is probably at or near a bottom and six to nine months away from a prospective recovery.

Not all segments of the stock market are equal beneficiaries of lower interest rates, however. Financial, health care, media, and retail stocks have gained the most in the wake of falling interest rates during previous cycles. Stocks in basic industries such as chemicals, paper, construction, real estate, energy, precious metals, and utilities rarely get much of a boost from lower interest rates—primarily because investors tend to favor stocks with higher growth potential and a closer link to the consumer after a period of decline.

And the Stock Market Shines! (Most of the Time)

There's another reason investors tend to reconsider stocks as short-term interest rates come down. As the yield falls below 3 percent on short-term cash equivalents such as certificates of deposit, money market mutual funds, and U.S. Treasury bills, the perceived risk of investing in the stock market goes down. At 3 percent, the after-tax and inflation return on cash equivalents is less than zero—a losing proposition to the minds of most investors.

Of course, there are no guarantees that falling interest rates will inspire a quick turnaround in stocks. In 1974 and again in 1981, two recessionary economies, the stock market continued to slide even after several interest rate cuts. Even so, we are not in uncharted waters. The U.S. economy and the stock market have weathered war, crisis, terrorism, presidential assassination, and the Great Depression—and still the long-term direction of both has been upward. The timing may be impossible to predict, but declining short-term interest rates are one important sign that has heralded the stock market and economic turnarounds of the past.