After an aggressive rate hike cycle that saw the Federal Reserve raise interest rates 11 times between March 2022 and July 2023—resulting in a total increase of 5%—the Fed has kept rates steady for the last six FOMC meetings. This pause signals that the fight against inflation may be nearing its end, and rates are likely to decrease soon. August Consumer Price Index (CPI) numbers rose only 0.2%, bringing annual inflation to a very normal 2.5% over the past 12 months.

As we enter a new monetary cycle, investors can expect a shift towards a more "dovish" approach, with the Fed focusing on balancing inflation with strong employment and economic growth. In simpler terms, the brakes are coming off, and monetary policy is set to loosen.

How Rate Cuts Impact Investors

Stay Focused on Long-Term Strategy

Even as rate cuts loom, it's essential to maintain a long-term, diversified investment strategy. Your portfolio should already be designed to weather changes in monetary and business cycles as well as unexpected economic shocks. Sweeping changes are not necessary.

If you feel adjustments are needed, take a slow, deliberate approach. There are no guarantees about when or how the Fed will act, and policy shifts could increase market volatility. Any changes should align with your goals and risk tolerance.

While a complete overhaul of your portfolio may not be required, there are some strategic adjustments you can make. But always evaluate potential opportunities considering your specific goals and risk profile. At Arrow, we continuously monitor the global economic situation and adjust asset and sector allocations accordingly for our clients.

What Lower Interest Rates Mean for Investors

Declining Returns on Low-Risk Investments

With the Fed's key short-term interest rate sitting above 5%, low-risk investments like Certificates of Deposit (CDs) have been attractive, offering solid returns for minimal risk. However, as rates drop, the returns on these investments will also shrink.

If you have funds you won't need in the next 6-18 months, it may be a good idea to lock in current higher rates before they fall. Still, weigh the tradeoffs before making any decisions. Investors will also see high yield savings account and treasury interest rates drop over the rate cutting cycle, forcing investors to take more risk to get higher returns. The movement of assets from low risk to higher risk investments is one of the main reasons the stock market tends to thrive in rate cutting environments.

Adapting to Lower Rates

Lower interest rates tend to encourage more spending by consumers and businesses, stimulating economic growth. However, the effects on different asset classes, such as stocks and bonds, are not uniform, meaning you may need to adjust your portfolio.

Bond Strategy: Watch Duration

As interest rates drop, bond yields typically decline as well, making newly issued bonds less valuable. In a rising rate environment, investors shorten the "duration" of their bond portfolio to reduce sensitivity to interest rate changes. Duration measures how much a bond’s price will fluctuate with interest rate movements.

When rates are falling, bonds with longer durations can appreciate in price, but they also carry higher interest rate risk. If the Fed unexpectedly reverses course and hikes rates again (for example, due to rising inflation), long-duration bonds could suffer significant losses.

Replacing Income Sources

As bond yields decrease, investors relying on their portfolios for income may need to explore alternative sources of returns. Dividend-paying stocks could become more appealing, particularly those in sectors with steady demand, such as:

• Utilities

• Consumer Staples

• Energy

• Healthcare

These stocks focus on distributing regular dividends, offering a potential buffer against declining bond yields.

Preparing for Potential Economic Growth

Sectors That May Benefit

Certain sectors may perform well as the cost of borrowing decreases. Here are some key areas to watch:

• Consumer Discretionary: Lower interest rates typically boost consumer spending on "nice-to-have" goods (as opposed to essentials).

• Industrials: Companies in this sector could benefit from lower borrowing costs, potentially driving stock prices higher and enabling expansion.

• Technology: The so-called Magnificent Seven tech stocks have led the market even amid higher rates. A lower rate environment may extend their dominance.

In addition to specific sectors, small-cap stocks might benefit from lower borrowing costs, allowing these companies greater flexibility to pursue growth.

Final Thoughts: Take a Measured Approach

A shift in the Fed's monetary policy will likely impact the economy by stimulating growth and force a movement from low-risk assets into higher risk assets. Rather than rushing into major changes, take a cautious, measured approach. This strategy will help you manage risk, stay aligned with your financial goals, and seize new opportunities as they emerge. By taking a thoughtful approach to your portfolio, you can navigate the upcoming rate cuts and position yourself for long-term success.