In this newsletter we’ll talk about how the impact of the recent 50 basis point rate drop are likely to make their way through the financial landscape.
What does the Fed control?
The Federal Reserve Bank meets eight times a year to discuss changes in the discount rate, or the rate at which member banks can borrow and lend to each other.
The Fed does not directly control investments, mortgages, or any of the financial instruments that we use in our lives. The relationship is indirect. Commercial banks that issue these instruments base their rates off the discount rate the Fed sets.
How do Fed changes ripple through?
Investments are sensitive to interest rates.
When interest rates are higher, it makes it hard for businesses to get loans from the bank, because they must pay out more in interest on that loan. This trickles down to corporate profits and ultimately earnings. When rates drop, the opposite occurs; business growth is stimulated. Earnings are what drive stock price changes, and companies with lower prices relative to earnings are viewed as more attractive by investors.
Consumer spending is sensitive to interest rates
Consumers are impacted similarly, with higher credit card interest rates and higher interest rates for loans leading them to hesitate to spend more. The opposite is true when the discount rate falls; this is an easier environment for consumer spending.
Bond prices and yields are impacted by interest rates.
Bond prices rise when rates fall. When rates fall, the interest rate on short term deposits like money market accounts fall. This tends to lessen the demand for these instruments, and heighten the demand for longer term bonds. Interest rate shifts impact all types of bonds – municipal bonds, corporate bonds, government bonds, etc., – whose prices are likely to rise with a drop in rates.
Mortgages are sensitive to interest rates.
The rate you get for your mortgage depends upon a confluence of factors – your credit history, the level of aggressiveness or conservatism of the lender, the duration of the mortgage, additional debt loads you may be carrying, etc. The starting point that your personal mortgage rate is derived from does tend to vary up or down in line with Fed rate changes.
What is the latest rate change?
On September 18th, the Fed decided to lower the discount rate by 50 basis points, or 0.50%. This was an aggressive move. While Fed policy changes can never be predicted with accuracy, it’s likely the Fed is going to keep cutting rates by gradual amounts until the labor situation reaches a point of stabilization.
Should you take any action?
It better to make decisions with a long term, multi-cycle perspective in mind rather than trying to predict what the Fed is going to do.
All risks, including market volatility due to changes in macroeconomic variables, must be managed by prudent asset allocation that lines up with your risk tolerance and long-term goals. If you would like to discuss your portfolio and financial plan, please let us know.
-Judd