On September 18, the Federal Reserve announced that it was lowering the target range of the federal funds rate a half point to 4.75%–5.00%. This is first cut since the Fed began hiking rates in March 2022 in an effort to combat the effects of inflation. It’s expected that this will be the first of potentially as many as 3 cuts by the end of 2024.
The move signals that the Fed now feels inflation is largely under control and has shifted its focus to shoring up the labor market, which has shown signs of softening in recent months.
Given this change, and the motivations behind it, it's important to consider what falling rates might mean for you and how they may impact your investment portfolio as well as your long-term estate and wealth-transfer plans.
No signs of recession, but volatility likely
Though markets have experienced some recent volatility, the Fed’s actions aren’t necessarily a sign that trouble is ahead. Instead, they should be seen as adjustments to changing circumstances meant to keep the economy on a growth trajectory.
“The Fed is trying to ensure that the interest-rate level isn’t so high that it starts to limit economic activity,” says Naveen Malwal, institutional portfolio manager for Strategic Advisers, LLC. “After all, the Fed’s mandate involves both managing inflation over the long run and maintaining a healthy level of employment. The Fed’s interest-rate cut is likely meant to support job growth. If anything, this is a sign that the Fed has gained more confidence that inflation is no longer a threat to growth and is now ready to shift its focus to jobs.”
Though recent jobs reports have shown the labor market softening a bit, Malwal points out that the current unemployment rate is still historically low. He says that the Fed is attempting to stave off a more severe decline.
“The Fed’s goal is to manage the interest-rate environment so that economic growth can continue for some time,” says Malwal. “This may, in turn, lead to a healthy job market.”
In general, Malwal is optimistic about the economy, and sees no indications that a recession is on the horizon. He anticipates a positive outlook for corporate profits for the remainder of the year and into 2025. “Banks are currently lending, which could potentially contribute to economic growth. And while some building up of inventories may suggest less spending on goods, consumers are still spending on services. It's important to note that these factors can fluctuate and may change in the event of a recession.”
"We continue to believe we're in a prolonged expansion," says Lars Schuster, institutional portfolio manager for Strategic Advisers, LLC. "Mixed economic signals are common in this phase of the business cycle. For long-term investors, periods of volatility are normal. Staying invested during those moments can contribute to their success in meeting a future financial goal."
Bonds could benefit
"The Federal Reserve raised interest rates rapidly and aggressively from 2022 to July 2023," says Malwal. "When this all started, inflation was close to 9%. Bringing it down to its current level took a lot of rate increases, which took a toll on bondholders. They experienced unusually high volatility because when rates go up, bond prices typically fall."
As rates fall, however, bond investors may get a boost. "Just as rising rates can hurt bond prices, falling rates may help," says Malwal. "Depending on the maturity of the bond, someone who already holds a bond before rates decline is likely to benefit from the higher yield available on their bond, and likely see their bond’s price rise if rates fall." That said, falling rates will also lead to lower yields on newer bonds. This may provide further incentive for investors to invest in bonds while interest rates and yields remain elevated.
"In this kind of environment, high-quality bonds may offer a variety of different benefits," says Schuster. "With higher yields you have the potential for a boost to returns that we haven't seen in some time. But there's also a diversification benefit. If the economy does slow and stock markets struggle, bonds have typically fared better than stocks during periods of extreme volatility. Therefore, an allocation to bonds may serve as the ballast that it has traditionally been even as rates come down."
Malwal cautions against trying to drastically reallocate assets to take advantage of short-term shifts in the market, however. "Investors may be better off figuring out a mix of stocks and bonds that they feel comfortable investing in for the long run rather than trying to guess when they should be in or out of stocks and bonds based on what's happening with rates," says Malwal.
What falling rates may mean for wealth and estate planning
Interest rates are a factor in several important wealth-planning strategies, and with rates potentially poised to fall further in the coming months, it may be a good idea to assess your needs.
For example, you may have an opportunity to move significant assets out of your taxable estate and into either a qualified personal residence trust (QPRT) or a charitable remainder annuity trust (CRAT).
"If we believe that interest rates are going to decline further in the near future," says Marc Morrone, a vice president on Fidelity's Advanced Planning Team, "transferring real estate becomes more attractive in the present." A QPRT allows a homeowner to transfer ownership of their home to a trust, removing the future appreciation of the real estate from their taxable estate while retaining the right to live in the property for a specified period of time. When that time period ends, the home passes to the beneficiary of the trust. "When interest rates are high, the value of the taxable gift is significantly reduced," says Morrone. With a CRAT, income produced by the assets held in the trust is distributed to noncharitable beneficiaries for the term of the trust. At the end of the term, what's left in the trust passes on to a charitable beneficiary. "If you've been contemplating either of these strategies," says Morrone, "now may be the time to execute on them."
As rates fall, techniques such as intrafamily loans, grantor retained annuity trusts (GRATs), and charitable lead annuity trusts (CLATs) may become more attractive. "Intrafamily loans are directly impacted by interest rates," says Morrone, and because they are governed by what's known as the Applicable Federal Rate, it may be possible for family members, such as parents, to offer other family members loans at rates well below what would be available from a commercial lender. It may also be possible to refinance intrafamily loans issued during a higher rate environment when rates are low.
Whether you're contemplating changes to your portfolio or looking to adjust your wealth or estate plan in anticipation of lower interest rates, it's important to consult with your financial and tax professionals to ensure that whatever move you make is something that will potentially help you achieve your long-term goals.