You might have heard that the Federal Reserve has cut interest rates by 0.25% to 2.25% at their meeting today. This is the first cut since 2008, and it looks likely that lower rates will prevail for longer than anticipated. But what exactly does that mean for you and your investments?
The Impact of a Fed Rate Cut
If rates were indeed to stay this low, then the effect it would have on different investments would be profound. This is because interest rates and bond prices have an inverse relationship. So, since interest rates are being lowered, bonds will yield less. Currently, the 10-year government bond yields just over 2%. This leaves stocks as one of the only asset classes left that look inexpensive relative to their potential yield. The results are even more profound if you consider dividends and share buybacks, which both represent cash returned to shareholders.
Dividends and Share Buybacks
Dividends are paid out to all shareholders while share buybacks increase the ownership stake of each shareholder. The cash returned by companies in the S&P 500i totaled $1.3 trillion in the last year; a yield of 5.3%. The average cash returned in the last 5 years totaled $1 trillion per year; a yield of 4.1%. By contrast, AAA corporate bonds with maturities of 20 years or more yield 3.5%. Furthermore, that yield will not grow overtime from your purchase price as the company’s earnings grow.
This means that an investor’s likely best choice is to invest in stocks. A lower interest rate for longer means that stocks should now be worth more than they would have been if rates were to increase or remain the same. And as you can see, it’s not even a close race between stocks and bonds.
i – The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.