Here’s What To Do When Interest Rates Drop

Question: With the Federal Reserve expected to lower interest rates this month, should I lock in rates for my money-market funds and government bonds?

Answer: Federal Reserve (Fed) officials for weeks have been telegraphing their openness to lowering interest rates later this month. Most prognosticators see a cut of 0.25 percentage points, but a few predict a half-point drop. While this move will directly impact money-market returns, certificates of deposit and other short-term bonds, a small reduction seems insignificant.

However, it’s important to understand that the Fed appears to be shifting into an easing cycle, potentially leading to much lower short-term rates over the next couple of years. Predicting the exact pace of these cuts is challenging. If unemployment remains low and inflation stays persistent, the Fed might ease rates more gradually, possibly even pausing at some point. Conversely, if unemployment rises or inflation cools, rates could be lowered more quickly.

While the timing is uncertain, most experts agree the destination is certain—lower rates—and markets have already priced in these expectations, which is why longer-term bonds are offering lower yields than shorter-term ones. So, how does a prudent investor navigate this declining, inverted yield curve?

Consider working with a financial advisor to evaluate your goals. Depending on your short-and long-term goals there are ways to divide your cash-and-bond portfolio into parts to take advantage of higher rates while they last.

For example, you could split your cash-and-bond portfolio into two parts. The first part could consist of funds you plan to spend or reinvest within the next two to three years. This portion could be invested in shorter-term bonds and money-market funds to benefit from higher, albeit declining, rates for as long as possible. The second part, earmarked for long-term fixed-income investments, could be shifted into mid- or long-term bonds. Although these may offer lower returns in the short run, they are likely to generate higher returns over the longer investment horizon.