What happens when interest rates go down? | Fidelity Investments (2024)

What falling interest rates may mean for markets

At the end of 2023, the US economy continued to show resilience. Stocks and bonds rallied at the end of the year, buoyed by stronger-than-expected consumer sentiment and a healthy job market. The US economy showed signs of continued expansion and inflation had cooled significantly from its peak in July 2022. Corporate earnings growth, though modest, exceeded expectations and the earnings outlook for 2024 is positive.

Some challenges were still present, such as mixed signals on manufacturing activity, while a few sluggish emerging market economies weighed on global growth. On balance though, the backdrop was one of continued growth.

"We continue to believe we're in a late-cycle expansion," says Schuster. "Mixed economic signals are common in this phase of the business cycle. Given these mixed signals, the direction of interest rates may depend largely on what happens with inflation. If inflation continues to ease, that will likely allow rates to come down and possibly support economic growth."

Though inflation has come down significantly, the path down to the Federal Reserve's 2% target may be uneven and challenging. "If inflation remains elevated, the Fed may not lower rates as much as markets expect," says Schuster. What might keep inflation higher? "Continued consumer spending in services supported by a tight jobs market and housing costs," he says. "In past cycles, we've seen the housing market moderate as rates rose. While sales have slowed, housing prices moved higher in 2023 given severe supply constraints. Many homeowners who were able to lock in low rates years ago are reluctant to move, which is keeping supply low and propping up home prices."

"Investors should expect that there may be some modest volatility as markets assess how economic and inflation trends may impact Fed policy, including future interest-rate cuts," says Schuster. "For long-term investors, periods of volatility are normal. Staying invested during those moments often best defines their success in meeting a future financial goal."

What about bonds?

Bond markets have been challenged over the last few years but ended 2023 on a strong note and may be poised for further gains in 2024.

"The Federal Reserve raised interest rates aggressively from 2022 to July 2023 in an effort to bring down inflation," says Naveen Malwal, institutional portfolio manager for Strategic Advisers, LLC. "Two years ago, inflation was close to 9%; bringing it down to 3% 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. Since the Fed paused its rate hikes, however, we've seen a fairly good recovery in bonds, which returned just north of 5% last year."

Malwal believes that if the Fed is in fact done raising rates and the futures markets are correct that rate cuts may be on the way, 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, plus see their bond prices 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 can serve a number 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, an allocation to bonds may serve as the ballast that it has traditionally been even as rates come down."

Malwal cautions against trying to 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 the market 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 the potential for rate cuts on the horizon, it's a good idea to take stock of which strategies may become more appealing in a lower interest rate environment and which strategies you may want to consider taking advantage of now, while rates remain elevated.

For example, while rates are high, 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 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."

If we do ultimately see rates begin to 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.

Conclusion

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.