How stocks, bonds, and cash perform when interest rates fall

Investing in stock and bond markets during interest rate-cutting periods has historically delivered inflation-beating returns.  

Analysis from fund group Schroders shows that in the 12 months after the US Federal Reserve starts cutting interest rates, the average return from US stocks has been 11 percentage points ahead of inflation. US shares outperformed government bonds by six percentage points and corporate bonds by five percentage points on average. 

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Stocks have beaten cash by nine percentage points in the 12 months after rates start to be cut, on average. Bonds have also been a better place to be than cash. 

This is based on analysis of investment returns during 22 US interest rate-cutting cycles since 1928. 

The research is very relevant today, as investors expect the Fed to begin rate cuts in the spring, with three cuts in total currently planned by the central bank in 2024.  

Falling interest rates increase the valuations put on stocks and bonds, as the risk-free rate delivered by US and UK government debt falls when interest rates drop, making riskier assets more attractive.  

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US shares are around 70% of the MSCI World index, which is a popular core allocation for investors via global tracker funds such as Fidelity Index World, HSBC MSCI World Ucits ETF, or iShares Core MSCI World Ucits ETF.  

Investors also access US shares directly via US trackers such as iShares Core S&P 500 Ucits ETF or the Vanguard S&P 500 Ucits ETF, which both regularly feature on ii’s most-bought ETFs list. They cost 0.07% a year in fees.  

Duncan Lamont, head of strategic research at Schroders, said that these returns are even more impressive considering that, in 16 of the 22 cycles, the US economy was either already in a recession when cuts commenced or entered one within 12 months. 

Stock returns were better if a recession was avoided but, even if it wasn’t, they were still positive on average. 

Lamont says: “There are big exceptions, and a recession is obviously not something to be welcomed. But for stock market investors it has not always been something to unduly fear either. 

“Bond investors, in contrast, tend to do better if a recession occurs. They usually benefit from safe-haven buying (especially government bonds), which drives yields lower and bond prices higher. But they’ve also done OK if a recession was avoided. Corporate bonds have outperformed government bonds, on average, in this more economically rosy scenario.” 

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Unlike most historical episodes, the Fed is not considering cutting rates because it is worried that the economy is too weak. It is doing so because inflation is going in the right direction, meaning policy does not have to be so restrictive. 

If it is right, and it can engineer a “soft landing”, where inflation goes back to target without a recession, then 2024 could be a good year for stock market investors and bond investors, Lamont says.  

Stock markets have started the year well. In sterling terms, the S&P 500 index of America’s leading shares has risen 2%, and the MSCI World index is up 1.7%. Meanwhile, global bonds have fallen 1.3%.