The Downside of Falling Interest Rates
From: www.nytimes.com
With the Federal Reserve expected to cut short-term interest rates later this month, investors face some tricky choices.
While falling rates are usually viewed as a boon for the stock market, that’s not the case for all parts of the investment universe. In fact, for money you may need soon, where safety is a major priority, falling interest rates aren’t great news at all.
Whenever short-term rate cuts start — and that could be as soon as the Federal Reserve’s next policymaking meeting Sept. 17-18 — the fabulous 5%-plus money market yields of the last couple of years will begin to decline. Faced with the prospect of less lucrative payments from money market funds, Treasury bills, certificates of deposits and the like, you may be tempted to take on greater risks in longer-term bonds or stocks.
But the hazards of the stock market were evident this past week, when share prices tumbled globally in a reprise of the brief market meltdown of early August over concerns that the economy might be slowing. On Tuesday alone, Nvidia, the chipmaker that has been at the forefront of the artificial intelligence boom, lost 9.5% of its value, or $279 billion. Stock investors need to be able to ride out market storms like these. But that also requires the ability to pay your bills while the stock market gyrates. Safe, short-term holdings are essential for that purpose.
I generally favor a long-term strategy emphasizing low-cost, broad index funds that you can hold for many years, and, preferably, decades. If you’ve got a very long horizon, whether interest rates rise or fall this year doesn’t matter all that much. But that only works if you have a great deal of time. The stock market has produced outstanding long-term returns, but for money you will need soon, the stock market isn’t the solution. You may just have to accept lower yields in return for safety.
So while falling rates are wonderful if you’re looking for a mortgage or a car loan, they are not an unambiguous blessing for investors. Here are some rough guidelines on how to think about the trade-offs that falling rates pose for investors.
Mental Buckets
Richard H. Thaler, the Nobel-laureate behavioral economist, says many of us engage in what he calls “mental accounting” — a tendency to put money into different boxes or buckets, depending on its intended use or source. I know this is true for me. For the money I believe I may need for my family in the next few years, I’m extremely conservative. On the other hand, for money that I think of as “long-term investing,” I emphasize stocks, and I’m comfortable with taking risks and withstanding losses.
However you analyze your own holdings, it’s important to know the point of your investing. This may seem obvious: You always want to make money with your money; you don’t intend to lose any of it. But separating your portfolio into buckets may be useful when thinking about interest rates because falling rates affect the individual buckets quite differently.
You may have the urge to shift money from an asset class that will be hurt by declining rates — money market funds, for example — into one that is likely to be helped by a rate cut, like the stock market.
But I wouldn’t make a change like that without a great deal of thought, if the money in the safe bucket was in the right place to start with. Stocks are so much riskier than money market funds that switching from one to the other is like changing your Sunday plans from walking in the park to climbing a steep mountain. If you’re not prepared, you’re asking for trouble.
Varied Effects
There’s no doubt that lower rates will make it harder to do well financially while parking your money in a safe place. For investments typically considered “cash” — money market funds, Treasury bills and the like — the effect of lower rates is negative. We just don’t know how negative because it’s not clear how low rates will go or how long it will take to get there.
But what is certain is that with a slight lag, the short-term interest rates you can earn as an investor follow the Fed’s lead. So if the Fed cuts rates, you will receive less money in yield fairly quickly for money market funds. There will be a slower but similar effect on Treasury bills or certificates of deposits. Once those holdings mature, you won’t be able to invest in new ones at as high a rate. If you stick with these kinds of short-term investments, you will just have to live with lower rates.
That unalloyed negative effect doesn’t hold for the stock market, where, all else equal, lower interest rates are generally bullish. There are several reasons for this. Companies can borrow more cheaply and consumers can finance purchases at lower cost, both of which bolster profits. Risk-seeking investors can finance share purchases with borrowed money more cheaply, too, leading to higher stock prices.
What’s more, stock prices may look more enticing — at least in comparison with short-term interest rates, once you can no longer receive the 5.3% annual yields that are common in big money market funds now, according to Crane Data.
But be careful. The stock market is forward-looking and prices already reflect the expectation of lower rates, so don’t assume a rally is a sure thing. Lower rates are favorable, but the market could drop if rates don’t fall as much as traders anticipate. And innumerable additional factors could shake up the market, not least of which is the presidential election.
Perplexing as the stock market may be, the situation is complex in different ways for bonds and bond funds, where lower rates are a mixed blessing.
On the positive side, a reduction in rates will increase bond prices, as a simple function of bond math. That’s because interest rates (or yields) and bond prices move in opposite directions. Bond fund returns come from two sources: income from yields and changes in the price of bonds. The immediate impact of a rate cut will be a boost in returns for bond funds because the increase in bond prices held by bond funds will dominate fund returns — at first.
But over longer periods, the reverse is true. Once rates are stable, bonds with lower yields will generate less income and that will lower returns, both for bond funds and for newly purchased individual bonds.
If you own a bond outright, you won’t be affected by a reduction in prevailing interest rates as long as you hold the bond until it matures. If you need to sell it, you will get a better price when market yields fall, but you won’t be able to buy a new bond with a yield as high as the last one’s. For that reason, it may seem appealing to buy longer-term bonds now to lock in higher interest rates.
But there are problems with doing this. First, longer-term bonds move more drastically in price when interest rates shift, so you will be taking on more risk and could lose money if you need to sell a bond before it matures. Second, bond interest rates aren’t controlled by the Fed, and they have already dropped substantially. Yields could rise again. Making big bets on interest rates, one way or another, is always risky. That may be fine for some of your holdings, but could cause problems for the money you really need.
Safety First
Maintaining a core asset allocation with broad index funds and cash holdings in money market funds and similar short-term securities is fairly simple and makes sense for most people. Except at the margins, and when your own life situation changes, I’d be careful about making major changes in your holdings simply because of a shift in interest rates.
For the money that you need to keep safe and handy, choices are limited. If you want to avoid risk, don’t buy stocks with money you may need for expenses in the next couple of years, such as financing someone’s education or paying a medical bill or the rent. That may mean you will receive substantially less in interest income next year. I’m not happy about that for my own money, but I accept it.
That said, I think it’s reasonable to try to be more precise about how much money you think you might need this year, versus next year or the year after. It may be smart to shift just a portion of your safe money to investment-grade bonds or bond funds of an appropriate maturity, locking in better rates than you are likely to receive from money market funds a year or two down the road. If it turns out that rates do rise again, and you need to sell your holdings, you may lose some money but the price of short-term bonds won’t drop much, compared with longer-term bonds.
Moving from money markets or bonds to stocks is another matter. You could increase your risks drastically. Data calculated at my request by Morningstar Direct showed that from 1926 until 2023, the S&P 500 declined in 31% of all calendar years. And 13% of the time, that big stock index was down over periods of five calendar years. That’s not my idea of a safe place for money I might need to call upon in an emergency.
Risk-taking is an essential part of investing and I’m all for it — as long as it’s well thought out, and I can afford to bear the risks. Lower interest rates will make safe, liquid money — cash — less attractive as an investment, and I may add to my bond holdings as a consequence. I hope that the cash and the bonds will make me calm enough to cope with the stock market’s wild ride.
