As we enter the fourth quarter we can make a prediction with reasonable confidence: short-term interest rates will move lower over the next 12-18 months. In fact, they have already begun to do so. Last month, the Federal Reserve reduced its target interest rate by 0.50% and signaled that more rate cuts are to come. As we explore below, such periods of falling rates have frequently been followed by above-average stock returns over 12-month time horizons. Rate-cut cycles have also coincided with positive bond returns.

However, while periods of falling short-term interest rates have supported portfolio returns broadly, we caution investors to consider two factors relevant to this rate-cutting cycle: 1) Like other rate-cut cycles, this cycle begins with above-average recession risk, and recessions have proven more harmful to stock returns than rate cuts have proven helpful. 2) Although short-term rates should continue to decline, these rates may not fall as far as expected—while long-term interest rates may have already reached their lows.

What Rate-Cutting Cycles Have Meant for Stock Returns

Periods during which the Federal Reserve has reduced its target interest rate have been positive for stocks. As Table 1 illustrates, during 10 of the 12 rate-cut cycles since 1957, U.S. large-cap stocks have delivered positive returns over the 12 months that follow the initial rate cut. Moreover, the average total return for large-cap stocks in these 12-month periods equals 15.4%, beating the average 11.9% total return of all 12-month periods over this same time frame.¹

In both respects—frequency of positive 12-month periods and average of total returns—rate-cut cycles produced superior stock performance than the average for all periods. Notable exceptions include the years of 2001 and 2007, when recessions occurring within 12 months following the first rate cut resulted in negative stock returns.

Further, the starting level of the S&P 500® appears to have had little effect on forward returns following the rate cut. As the table shows, six of the 12 rate-cut cycles began with the index trading within 5% of its all-time high. In all but one of these cycles, the S&P 500® produced positive returns over the next 12 months, or 9.5% on average. ² While these periods may not have produced performance as strong as other rate-cutting cycles, the positive returns generated—despite stocks entering rate-cutting cycles near their all-time highs—are encouraging for today’s investors.

The historical record of post-rate-cut stock performance is murkier as the time horizon extends. For example, following the rate cut of May 1989, the S&P 500® produced a total return of 17% over the ensuing 12 months—and then fell more than 10% as oil prices rose in response to Iraq’s invasion of Kuwait, leading the U.S. economy into recession. In addition, the recessions of 2001 and 2007-08 continued to weigh on stock returns beyond the 12-months that followed the start of those rate-cut cycles. ³ Finally, it also bears noting that the path toward positive returns following an initial rate-cut has occasionally been volatile. While the S&P 500® delivered positive 12-month returns following the rate cut of July 2019, it did so only after falling over 25% from its pre-rate-cut level during the spring of 2020. ⁴ In short, while the historical record of stock performance following rate cuts is generally positive, the salutary effect of rate cuts on stock returns is far from assured.

What Rate-Cutting Cycles Have Meant for Bond Returns

The record of post-rate-cut performance is more straightforward when it comes to bonds. This is especially true when bonds are compared to cash. The relationship is secured by a fundamental rule of finance—namely that bond prices and interest rates are negatively correlated. Lower interest rates, in other words, lead to higher bond prices. In fact, since 1980, the U.S. Aggregate Bond Index has outperformed cash (i.e., money market funds) in the 12 months following five of seven interest-rate reduction cycles. ⁵ This observation is especially relevant for investors tempted by cash yields that are higher today than bond yields. As the Federal Reserve lowers its target rate, cash yields will fall, leaving cash investors earning lower-and-lower interest rates. Bond investors, on the other hand, will have locked in interest rates over the maturity of their bonds, while also benefiting from increasing bond values as interest rates decline.

However, just as we encourage caution regarding post-rate-cut stock returns, we also encourage some caution on post-rate-cut bond returns. In particular, we note the possibility that longer-term bond yields (10 years and beyond) are not assured to fall in tandem with short-term bond yields. We offer three reasons why long-term bond yields may not fall much from their current levels.

First, long-term rates reflect investors’ expectations for future short-term rates. And there are reasons to expect that the Federal Reserve will not lower its target rate as aggressively as the market anticipates. The U.S. economy’s above-average growth in late 2023 and through the first half of 2024—a period marked by the highest level of short-term interest rates in over 17 years—suggests that high interest rates have been less restrictive to economic activity. ⁶ As a result, the Federal Reserve may not need to lower interest rates much for economic growth to continue at a desirable pace. Second, an improved growth outlook could lead to an increased possibility that inflation rises above the Fed’s 2% inflation target. Should inflation concerns reemerge, buyers of long-term bonds would demand lower prices (that is, higher yields) to assume the risk that inflation erodes their purchasing power. Third, long-term bond yields tend to exhibit less volatility than short-term bond yields, as Chart 1 shows. ⁷ In our view, yields of short-term bonds are more likely to fluctuate as investors assess the schedule and pace of the Fed’s rate-cut cycle. Longer-term bond yields, on the other hand, are more likely to trade in a tighter range from current levels—if not higher—as investors revise their expectations for short-term rates and inflation risks. This view leads us to favor intermediate-term bonds (3-10 years to maturity) over long-term bonds.

Conclusion

On average, rate-cut cycles have been supportive of portfolio returns. We use history as a guide, however, and not as a rulebook. As longer horizons prove, unknown and underappreciated risks have made such rulebooks less than perfect. As always, our best tools are diversified portfolios that can withstand these underappreciated risks—and intellectual humility to acknowledge our limited ability to predict them.

¹ Bloomberg, S&P 500 Index returns from Nov. 1, 1957 through September 30, 2024. Max drawdowns represent largest price drop from the S&P’s level the day preceding the initial interest-rate cut over the ensuing 12 months. Dates of initial rate cuts derived from changes in the upper bound of the Fed Funds target rate. Prior to 1970, rate-cut dates determined by changes in effective Fed Funds rate (FEDL01 Index).

² Bloomberg, S&P 500 Index.

³ Bloomberg, S&P 500 Index. Although the initial 12 months following the rate cut of May 31, 1989 produced relatively strong stock performance, the following six months saw U.S. large-cap stocks fall by 12% in price after Iraq invaded Kuwait. In addition, months 13-18 of the 2001 and 2008 rate-cut cycles saw stocks continue to drop in price, by 17% and 28%, respectively.

⁴ Bloomberg, S&P 500 Index, price return from 7/30/2019 to 3/23/2020.

⁵ Bloomberg. U.S. Aggregate Index (LBUSTRUU Index) and ICE BofA U.S. 3-Month Treasury Bill Index (G0O1 Index). Index data available only from 1977.

⁶ Bloomberg, Bureau of Economic Analysis. From the second half of 2023 through the first half of 2024, U.S. real GDP growth has averaged 3.1%. For the 10 years that preceded the Covid-19 pandemic, U.S. real GDP grew at an average of 2.4%.

⁷ Bloomberg, 30-year average yields and annualized volatility for U.S. Treasury bills, notes, and bonds (3-month, 6-month, 1-year, 3-year, 5-year, 7-year, 10-year, 20-year, and 30-year). Interpolated yields and volatilities for other maturities. 20-year bond yields and volatility since inception.

DISCLAIMER: The information provided in this piece should not be considered as a recommendation to buy, sell or hold any particular security. This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions, or forecasts will prove to be correct. Actual results may differ materially from those we anticipate. The views and strategies described in the piece may not be suitable to all readers and are subject to change without notice. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. The information is not intended to provide and should not be relied on for accounting, legal, and tax advice or investment recommendations. Investing in stocks involves risk, including loss of principal. Past performance is not a guarantee of future results.

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