On September 18, 2024, the Federal Reserve voted to lower the benchmark federal funds rate by 0.50%, marking the first cut since April 2020 during the COVID-19 pandemic. This time around, the Fed is signaling that it is just the beginning of normalizing short-term interest rates with more cuts still to come.
As a result, market expectations suggest that the federal funds rate and other short-term interest rates will likely end 2025 near 3%, while long-term rates, such as 20-year Treasury bonds, are expected to remain around 4%.
That leads us to ask two big questions. What does the Fed’s cut mean for me and my assets? And what, if anything, should we expect to change in the future?
Question 1: What does the cut mean for individuals and various financial assets?
1. Cost of Short-Term Borrowing: Good news for individuals who are borrowing in the short term, using instruments like credit cards, stock-based margin, car loans, or homeowners in the variable period of an adjustable-rate mortgage, as these rates will move down with Fed cuts. This means that short-term borrowing is expected to get cheaper over the next year.
2. Money Market/CD/Savings Account Rates: Not-so-good news for savers. A lot of these rates have been near or above 5% over the past year but will come down in conjunction with the reduction in Fed rates. The market expects these short-term rates to be around 3% or lower within the next 12 months.
Borrowing gets more attractive, but investing in cash/cash equivalents, less so. To continue earning higher returns, many individuals with excess cash will likely need to invest at least a portion of it in higher-return assets, such as stocks and bonds.
3. Mortgages: The news is not great for those hoping to see lower mortgage rates in the near future.
Mortgages, which are long-term debt, are tied to longer-term interest rates like 10-year Treasuries. At the end of 2023, the yield on 10-year Treasuries was 3.88%, compared to 3.81% as of September 30, 2024 — not much change.
Basically, long-term mortgage rates are not expected to move, nor should they be affected much, by the Fed continuing to cut short-term rates since fixed-rate mortgages move with long-term rates.
4. Future Portfolio Expected Returns (Expected Returns on Stocks and Bonds): Expected returns for both bonds and stocks — typically around 5% over 10-year Treasury bonds — are largely influenced by long-term interest rates. As we saw with mortgages, long-term rates have remained relatively flat year to date. As a result, expected portfolio returns have stayed nearly unchanged this year and are unlikely to be significantly impacted by further declines in the federal funds rate.
Question 2: What does this mean for the future in terms of further rate cuts?
To get some guidance on future interest rates, we can look at what Fed officials expect moving forward and what the market is telling us.
In his remarks, Fed Chair Jerome Powell claims that inflation is progressing toward the target of 2%, with the Consumer Price Index showing a 12-month rate of 2.4% through September 2024, down from 3.7% in the prior year.1
Compare this to market inflation expectations over the next five years, currently 2.07%.2 So, the market aligns with the Fed's view that inflation is likely to remain near the target moving forward.
This cooling of inflation allows the Fed to focus on the other part of its dual mandate, which is to try to keep the country near full employment. Full employment is usually thought of as around a 4% unemployment rate. The unemployment rate after the COVID-19 pandemic reached a high of 14.8% in April 2020 when much of the country was shut down. In the aftermath, the government reported that it dropped to a low of 3.4% in April 2023.
As the Fed kept rates high to cool inflation beginning in 2022, the constrictive nature of high rates on the economy has caused the unemployment rate to increase to a reported 4.1% (as of September 2024). Although the long-term average is about 5.7%, the risk of unemployment continuing to rise forced the Fed into lowering rates at their last meeting.
Here’s the bottom line: the market provides our best “crystal ball” into the future. Although not flawless, market expectations reflect the most likely outcomes based on the information available today. Since markets are efficient, most of the market expectations on the effects of these cuts are already priced into bonds and into stocks. It is hard to outguess those expectations!
As stated at the beginning of this piece, market expectations are that the Fed will continue to cut the federal funds rate from 5% currently to about 3% by the end of 2025. Regardless of where rates end up this time next year — which is unpredictable — we can incorporate current market expectations into our decisions, whether using debt to finance short-term purchases or investing excess cash to earn higher returns over the long term.
Sources
1 U.S. Bureau of Labor Statistics, 12-Month Percentage Change, Consumer Price Index, Selected Categories retrieved from https://www.bls.gov/charts/consumer-price-index/consumer-price-index-by-category-line-chart.htm, October 10, 2024.
2 As of 09/30/24. Market inflation expectations are derived from the spread between 5-year yield on Treasury Inflation Protected Securities (TIPS) versus 5-year yields on nominal Treasuries found at https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value=2024 and https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_real_yield_curve&field_tdr_date_value=2024
3 U.S. Bureau of Labor Statistics, Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UNRATE, October 4, 2024.