Why the Federal Reserve May Cut Rates, and What it Means for Your Portfolio

This past Wednesday, the Federal Reserve Open Market Committee met and decided not to change interest rates, keeping rates where they are for 2019 (so far). The Fed did leave open the possibility of a future rate cut.

Juxtapose this with the S&P 500 hitting a record close on Thursday and the yield on the 10-year Treasury dipping at one point during the day below 2%. Interesting because these two items are usually more associated with a future rate increase and not a rate cut.

A rate cut would be a curious move since the Fed’s statutory goal is maximum employment and price stability (inflation), both which seem to be where the Fed wants them to be.

The unemployment rate for May was 3.6%, unchanged from April, and the lowest it has been in 50 years.

Inflation in May, according to the Bureau of Labor Statistics, increased .1% (seasonally adjusted), and 1.8% over the past year.

So, Why is the Fed Talking About a Rate Cut?

In their press release on Wednesday, the Fed reaffirmed its view of “sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2% objective.” They also cautioned that “business fixed investment has been soft” and “uncertainties about this outlook (positive) have increased.”

In other words, the Fed is saying that while things are good today, they see some signs that the economy may soften, and if so, they are prepared to “act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2% objective.”

Nowhere in the press release does the phrase “rate cut” appear. But given the Fed’s main tool for maximum employment and price stability is monetary policy, a reduction in rates is assumed (by Wall Street at least).

Stock market investors and bond investors interpreted the Fed’s inactions differently.

Stock market investors looked at the Fed’s willingness to cut rates as a sign that it will be proactive if economic growth slows, lessening—or possibly eliminating—the chance of recession. The Fed cuts rates to spur borrowing by both individuals and businesses, which in turn creates economic growth.

Bond investors looked at the potential of a rate cut as a sign the economy may already be slowing. Slowing economic growth causes investors to move out of stocks and into safe-haven investments, such as bonds. More money in the bond market pushes yields down and prices up.

So this, of course, brings us to the question…

What Should Investors Do if They Suspect a Rate Cut is Looming?

Let’s say more signs start to appear that the economy is slowing. The initial thought would be to move away from stocks and into bonds. There are two problems with that theory.

First, the data that would suggest the economy is slowing won’t be known until after the growth has started to slow, putting you behind the eight ball.

Second, the Fed has intimated that if growth slows, they will cut rates, which hopefully will spur growth.

If you think the economy will continue to grow and that even if it starts to slow, a rate cut will mitigate the effects of that happening, should you move away from bonds and into stocks?

Probably not a wise idea, either. Cutting rates does not guarantee an economy will stop slowing and grow.

The best strategy, as always, is to maintain your current asset allocation as determined by your goals. Altering your plan on a guess about the economy—even an educated one—is likely to cause your portfolio more harm than good.

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