Between March 2020 and July 2023, the Federal Reserve Bank (Fed) raised the federal funds interest rate 11 times. The goal? To stifle historically high inflation.
Now that inflation has cooled, the Fed expects to reverse course. The latest projections predict three interest rate reductions in 2024, with more to follow in 2025 and 2026.
With lower interest rates on the horizon, you might be wondering how to position your investment portfolio for the changing economic conditions. Read on for the answers. Below you'll get up to speed on interest rates and, specifically, what the current interest rate is and which sectors stand to benefit as rates fall.
How Do Interest Rates Change?
The Federal Open Market Committee (FOMC) is the group in charge of interest rates in the U.S. They meet eight times annually to set a target federal funds rate—which is the rate commercial banks use to borrow money from one another.
Changes to the fed funds rate prompts corresponding changes to the prime lending rate. And the prime lending rate is a primary pricing factor in many variable-rate debt products. Specifically, you'll often see rates quoted at the prime rate or the prime rate plus a margin.
So fed fund rate changes flow through the prime rate to affect credit card rates, adjustable-rate mortgages, rates on home equity line of credit (HELOCs) and more. Market rates on new fixed-rate loans also mirror changes in the fed funds rate.
What Is The Current Interest Rate?
In January 2024, the target fed funds rate is a range of 5.25% to 5.5%. The prime rate is 8.5%. In March 2020, these rates were 0% to 0.25% and 3.25%, respectively. That equates to interest rate increases totaling 5.25 points since the first half of 2020.
How The FOMC Uses Interest Rates
The FOMC uses target interest rate changes alongside open market operations to promote sustainable economic growth. Open market operations include buying or selling U.S. Treasury debt to influence the money supply. These actions encourage banks to adopt the FOMC's target rate.
Rate increases discourage the use of borrowed funds, which can slow an economy that's growing too quickly. Rate decreases do the opposite. They stimulate borrowing, which can prompt economic growth.
Rate hikes in recent years were specifically targeting inflation. Inflation rates in 2021 and 2022 were 7% and 6.5%, respectively. By the end of 2023, inflation had tempered down to 3.4%. The Fed's target inflation rate is 2%.
Although inflation is still higher than the self-imposed target of 2%, the Fed has signaled its intention to lower rates in 2024. The goal of that effort is to avoid recession. Current projections indicate the fed funds rate may dip to 4.6% from its current range of 5.25% to 5.5%. By 2026, the fed funds rate is expected to move below 3%.
What Are The Impacts Of Lower Interest Rates?
Lower interest rates encourage borrowing and reduce the cost of variable-rate debt. That combination generally benefits business earnings, which drives investor interest and pushes stock prices higher.
Unfortunately, there can be other outcomes, too. Falling interest rates are associated with a slowing economy—which ultimately can be more influential to business earnings than interest rate changes.
This underscores the importance of keeping a long-term investing view. News of lower interest rates tends to energize equity investors, which pushes stock prices higher. But how the economic climate plays out in the months ahead is still uncertain. We might see the market stay on a growth trajectory or, if the economy continues to slow, things might go the other way.
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Sectors Which May Benefit From An Interest Rate Cut
Certain economic sectors can benefit from falling interest rates. Depending on the circ*mstances, the consumer discretionary, information technology, utilities, real estate, consumer staples and/or materials sectors may see a boost as rates drop.
Below is an overview of each of these six sectors, along with explanations of how they can be affected by interest rates. All performance stats are total return metrics from the corresponding . Total return includes appreciation and dividends.
1. Consumer Discretionary
- Year-to-date 2024: -2.0%
- 2023: 42.4%
- 2022: -37.0%
- 2021: 24.4%
- 10-year annualized return: 11.8%
Consumer Discretionary Overview
The consumer discretionary sector includes non-essential goods and services. These are things like cars, entertainment activities, furniture and designer clothes. Companies in this sector include Amazon
Why Consumer Discretionary Benefits From Lower Interest Rates
Lower interest rates reduce new borrowing costs and costs on existing variable-rate debt. Those two factors often encourage consumers to increase their discretionary purchases. This is especially true for households that have been limited to necessary purchases recently. When funding becomes available, pent-up demand can prompt higher spending on small and large luxuries.
2. Information Technology
- Year-to-date 2024: 57.5%
- 2023: 57.8%
- 2022: -28.2%
- 2021: 34.53%
- 10-year annualized return: 21.3%
Information Technology Overview
The information technology sector includes businesses that build computer software, hardware and other technology-driven products and services. Examples are Apple
Why Information Technology Benefits From Lower Interest Rates
Information technology is a capital-intensive sector. Businesses must innovate constantly to remain competitive. That requires ongoing investment in research and development as well as acquisition and other expansion initiatives. Lower interest rates provide cheaper funding for those activities.
The big beneficiaries will be mid-cap tech stocks and tech stocks with high debt balances. The largest tech companies and those with conservative balance sheets, like Apple and Microsoft, will see a lesser benefit.
3. Utilities
- Year-to-date 2024: -9.4%
- 2023: -7.1%
- 2022: 1.6%
- 2021: 17.7%
- 10-year annualized return: 8.3%
Utilities Overview
The utilities sector includes businesses that provide services related to electricity, water, gas and renewable energy. Constellation Energy
Why Utilities Benefits From Lower Interest Rates
Utilities stocks are defensive dividend-payers. In terms of investment dollars, they compete with bonds. Bonds become less attractive when interest rates drop. That, in turn, increases the relative appeal of utilities and their dividend payments.
As a result, low-rate environments will encourage income investors to shift away from bonds and into utilities stocks. The greater demand puts upward pressure on utility stock prices.
4. Real Estate
- Year-to-date 2024: -2.9%
- 2023: 12.4%
- 2022: -26.1%
- 2021: 46.2%
- 10-year annualized return: 8.2%
Real Estate Overview
Real estate companies own and manage properties, usually for the purposes of leasing them to residential, commercial, retail or hospitality customers. Public companies in the real estate sector include Public Storage
Why Real Estate Benefits From Lower Interest Rates
Property investments are financed. Lower interest rates mean lower debt payments for property buyers. And lower debt payments improve the economics of property deals. As a result, real estate companies can increase their investing activity and grow their portfolios. That gives them more inventory to lease out to customers. The end result should be sales and profit growth.
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5. Consumer Staples
- Year-to-date 2024: -0.2%
- 2023: 0.5%
- 2022: -0.6%
- 2021: 18.6%
- 10-year annualized return: 8.7%
Consumer Staples Overview
The consumer staples sector produces and sells essential items such as groceries, household cleaners and hygiene products. Companies in this sector include retailers like Costco (COST), Walmart
Why Consumer Staples Benefits From Lower Interest Rates
Consumer staples is a defensive sector, meaning that it's not terribly reactive to economic cycles. This is because people continue buying groceries and toilet paper even when the economy goes sideways.
Falling interest rates can affect this sector in two ways. First, as noted, lower interest rates can reduce household debt costs and improve spending power. These outcomes benefit consumer staples retailers that also sell discretionary goods. Shoppers at Target and Walmart, for example, may start putting more items in their carts.
Second, if the falling interest rates cannot prevent recession, many investors will likely move into consumer staples stocks defensively.
6. Materials
- Year-to-date 2024: -3.6%
- 2023: 12.6%
- 2022: -12.3%
- 2021: 27.3%
- 10-year annualized return: 8.3%
Materials Overview
Materials stocks produce chemicals, metals, construction materials and paper products. Public companies in the materials sector include Sherwin-Williams
Why Materials Benefits From Lower Interest Rates
Unlike consumer staples, the materials sector is reactive to economic cycles. In good economies, increased construction, transportation, production and packaging activity drives demand for input materials. In slow economies, the opposite happens.
If interest rate reductions have the desired effect of stimulating a slowing economy, the increased production should benefit materials producers.
Investing Strategies For Success
The relationship between the fed funds rate and the stock market is complex. On the surface, lower interest rates benefit stocks. But the underlying issue is a slowing economy. While the hope is that lower interest rates will reverse that slowness, nothing is certain in economic matters.
As an investor, it's smart to acknowledge and manage for that uncertainty. Three strategies that can help are: Diversify your assets, keep a long-term view and stay informed on economic indicators.
Diversify Your Assets
Diversification is the investing equivalent of not putting all your eggs in one basket. Rather than holding assets that move in lockstep with one another, build your portfolio from assets that behave differently. In times of economic change, some assets may respond mildly in one direction and others may respond wildly in another direction. When that happens, the net effect on your portfolio should be more moderate.
Stay invested in stocks that represent different sectors, company sizes and geographies. An example would be adding a small-cap or mid-cap fund to hold alongside an . Doing so should reduce your portfolio's volatility and spare you from the most extreme edges of stock market cycles.
Keep a Long-Term View
The long-term investing approach involves managing your stock portfolio so that you can wait out any downturns. There are two main components here. One, invest only in good companies that have staying power. Limit exposure to stocks that are only attractive under specific circ*mstances—because, inevitably, the economy will go the wrong direction and leave you holding an asset you don't want.
And two, keep a solid cash balance on hand. This is your funding for unexpected expenses, so you won't have to reach into your investment account to cover emergencies.
Cash on hand is especially important if you're investing in a retirement portfolio. It's very difficult to recover from an early 401(k) or IRA withdrawal.
Monitor Economic Indicators
Under a long-term investing approach, you won't overhaul your portfolio with every sign of a changing economy. Even so, the rise and fall of economic indicators should inform some of your financial decisions. Rising unemployment, for example, may prompt you to increase your cash emergency fund. Or you might shift more money into income-producing assets.
Key economic indicators to watch include:
- Gross domestic product (GDP) is the price-adjusted value of goods and services produced nationwide.
- Unemployment rate estimates the percentage of the workforce that doesn't have a job.
- Consumer price index (CPI) gauges inflation. As noted above, the Fed targets an inflation rate of 2%. When the CPI points to inflation that's much higher, there's a good chance the FOMC will address it with higher interest rates. In that environment, you may want to reference these best investments for high inflation.
- Retail sales data published by the Census Bureau shows broad trends in consumer spending. Higher retail sales signals a strong economy, under which stocks often perform well.
Bottom Line
Lower interest rates can signal good news or bad news for the economy and the stock market. Keep that in mind as you optimize your portfolio for the months and years ahead. Stay diversified and be ready to wait out an unexpected stock market turn. Also, let the economic data inform your larger financial strategy.
Follow those guidelines and you can thrive financially no matter what conditions lie ahead.
Read Next
- 10 Best ETFs For 2024
- 10 Best Stocks For 2024
- 4 Best Mutual Funds For 2024
The brain trust at Forbes has run the numbers, conducted the research, and done the analysis to come up with some of the best places for you to make money in 2024. Download one of Forbes' most popular and widely anticipated reports, 12 Best Stocks To Buy for 2024.
