The futures market is pricing in a 100 percent chance of an interest-rate cut by the Federal Reserve at its September 18, 2024, meeting. What does that mean for your investment? The answer is complicated because interest rates are but one variable of many. We can control for other variables by invoking the Latin phrase “ceteris paribus.” The phrase means “all other things being equal.” It acts as a shorthand indication that one economic variable could affect an outcome so long as all other variables remain the same.
Of course, controlling other variables is only possible in the equation—not in real life. The other complication is that the variable (interest-rate cuts) can be defined by timing, pace, and magnitude. To truly know how to adjust your portfolio in anticipation of interest rates, you need to apply the math, make a forecast (and hope you get that correct), and artfully guess the direction of dozens, if not hundreds, of both known and unknown variables. There is a “right” investment, but there is only knowledge in hindsight. Nonetheless, wisdom and experience can play a role where knowledge is absent. If you accept the premise that (gulp) 34 years of investing has granted me a bit of wisdom, here is what I expect to come from interest rate cuts:
- Investment-grade-bond prices rise. Bonds generally pay a fixed interest rate, so they become more attractive to investors when other interest rates fall. That drives up bond demand and increases their market price.
- Junk bonds become more attractive. Lower interest rates typically offer cash-flow relief to indebted companies, making bankruptcies less likely. Because default rates decrease (making them less risky), investors buy those higher-yielding “junk” bonds.
- Stocks re-rate higher in price. A lower interest rate means a lower discount rate. In valuation calculations, the discount rate refers to the rate used in discounted-cash-flow analysis to determine the present value of future cash flows in a discounted-cash-flow analysis. Don’t worry about the calculation; just understand that a lower discount rate leads to a higher valuation.
Lower interest rates allow consumers to buy more of everything because borrowing costs less. Lower credit card, car loan, and mortgage rates leave more discretionary income for other goods and services. Some interest rates have already come down in anticipation of a Fed easing cycle. For example, last week, the average 30-year fixed-rate mortgage in the U.S. receded to as low as 6.49 percent.
(To be precise, the mortgage rate is not tied to the Federal funds rate. However, the mortgage rates correlate to the ten-year Treasury yield, which has declined in part due to expectations of the Fed’s actions and also factors associated with the unwinding of the yen-carry trade.)
That 6.49 percent rate was the lowest 30-year fixed rate since May 2023 and is down from a cycle high of 7.85 percent in October 2023. Higher mortgage rates have contributed to the unaffordability of houses, driving home sales in 2023 to their lowest full-year level since 1995. Higher mortgage rates combined with soaring prices drove home sales down to 4.09 million units in 2023, 19 percent fewer than the prior year. Over 30 years, a percentage point or two can cost a homebuyer hundreds of thousands of dollars.
The median home price in the U.S. is $426,900. Factoring in a 20 percent downpayment, a 6.49 percent 30-year fixed rate translates to a lifetime interest payment of $433,168. At 7.85 percent, that amount becomes $547,800, or $114,000 more. Looking at it another way, the lower rate reduces the homeowner’s monthly payment by $314.
Lower mortgage rates will be helpful to homebuyers, but more relief is required to reinvigorate home sales. That relief may not come from lower mortgage rates alone; stagnant house prices are needed to make the reduction of interest rates meaningful to buyers. Job losses may be necessary to halt the rise of housing prices, in which case the benefit of lower rates may not be enough of a silver lining to stave off a recession and keep investment portfolios afloat.
There are other ways to drive housing prices lower. Per the law of supply and demand, more houses for sale should lower prices. Many homeowners are locked into three percent mortgage rates and are unwilling to sell their homes and switch to a different house with significantly higher rates. The current theory is that lower interest rates would prompt current homeowners to put their houses up for sale. But that is just theory. The good news for home buyers is that there were 1.32 million homes for sale in June 2024, up 3.1 percent from May and up 23.4 percent from June 2023. That increase in inventory has yet to mean lower home prices, but it should prevent significantly higher prices.
Home prices are unlikely to fall significantly without the unwanted assistance of a recession. Recession risks are higher now than in a “normal” year, but it is still not my baseline scenario. My investments align with continued economic growth, jumps in productivity from the adoption of artificial intelligence tools, higher unemployment due to a growing labor force (as opposed to layoffs), and the federal funds rate coming down from about 5.25 percent to 2.6 percent over the next few years (according to the Fed’s Summary of Economic Projections).
Party Like it’s 1999?
Speaking of being an investor for 34 years, I can’t help but shake the dangerous feeling that the next few years may be analogous to the mid-1990s to 1999. That was a disinflationary period characterized by the ubiquitousness of innovative technology (the internet then; artificial intelligence now) and a rate-cutting campaign by the Federal Reserve. (The Fed cut the federal funds interest rate from six percent in July 1995 to 4.75 percent in November 1999.)
Those halcyon years for the stock market ended in a massive crash, but they sure were fun until we reached that point. I don’t expect that type of party-like-it’s-1999 stock market fervor, but the similar setup provides context for my persistence in remaining invested despite elevated recession risks.
Well, that didn’t last long
You are most likely reading this column on Monday, August 26, 2024, or a bit later. But do you remember how the S&P 500 dropped 4.5 percent intraday on Monday, August 5, 2024? Well, guess what? As of August 14, the index closed above its 50-day moving average (DMA) for the first time in the month. (The 50-day moving average is a trendline that tracks the medium-term trendline of the index.) It may seem exceedingly fast for that to have occurred in seven trading days; however, that was the historical median pace, according to Bespoke.
That big Monday drop brought the S&P 500 down by a total of 8.5 percent at the time. Of the 44 times the index has declined five to 10 percent from its all-time highs, it was back to its 50-DMA at a median of seven days (an average of nine). The move was a whopping 5.3 percent in seven trading days for this occurrence. That is the good news.
The other news (not necessarily bad news) is that after those significant gains following those previous declines, stock market returns tended to be muted one year later, with an average increase of 5.9 percent. Admittedly, that is a good return. But it does pale in comparison to the early easy money. Although on August 15, the index broke above its 50-DMA convincingly with a 1.7 percent gain, so maybe more is in store for the market than an average 5.9 percent gain in the next 12 months. But don’t get your hopes up; the more reasonable takeaway is that corrections ranging from five to 10 percent are not signals of bad times ahead. I am maintaining my long-equity positions, which are primarily domestic, large-capitalization corporations.
Allen Harris is an owner of Berkshire Money Management in Great Barrington and Dalton, managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
