Investors are anticipating that the Federal Reserve may soon begin to cut rates, as May's U.S. Consumer Price Index (CPI) data came in lower than expected.

Interest rates are crucial as they impact the prices of various assets like stocks, bonds, and commodities.

If the Fed starts cutting rates, how should investors respond? This article will outline the Fed’s potential moves and identify which assets might benefit from rate cuts.

When will the Federal Reserve cut rates?

Since March 2022, the Federal Reserve has been raising rates to curb inflation. After 11 rate hikes, U.S. interest rates have risen to 5.25%-5.50%.

Source: Trading economics

As expected, U.S. inflation has receded. The latest CPI data for May 2024 shows a CPI of 3.3%, lower than the anticipated 3.4%. It marks a significant drop from the 6% level at the beginning of 2023, moving closer to the Federal Reserve's 2% target.

Source: Trading economics

So, when will the Federal Reserve cut rates? We can look at two aspects: the Federal Reserve's dot plot and the CME FedWatch Tool.

1. Federal Reserve's Perspective: The signals from the Fed remain hawkish. The latest June dot plot indicates that officials now expect only one rate cut in 2024. More precisely, the median expectation for rate cuts this year has been reduced from three in March to just one, with four officials even anticipating no cuts this year, up from two in the previous dot plot.

Source: Federal Reserve Board

2. Market Perspective: The market holds a more optimistic view on rate cuts. According to the CME FedWatch Tool, by the end of 2024, there's a 31.3% chance of one rate cut, a 43.6% chance of two cuts, and a 17.7% chance of three cuts (each 25 basis points). This indicates that the market leans towards expecting two rate cuts in 2024, with the first cut potentially occurring in September or November.

Source: The CME FedWatch Tool. Data as of June 18, 2024.

How to allocate assets in a rate cut scenario

The Federal Reserve's rate cuts could positively impact U.S. stocks, bonds, and gold. Here's an analysis of each:

Interest rates and the US stock market

Rate cuts could positively influence the overall valuation of U.S. stocks. Stock valuations are sensitive to interest rates because Wall Street often uses the Discounted Cash Flow (DCF) model for valuation. The DCF model essentially assesses a company's value based on future cash flows and the discount rate.

If the future cash flows remain constant, a lower discount rate (derived from the Federal Reserve's risk-free rate) increases the present value of these cash flows, boosting the stock's valuation.

While rate cuts generally benefit the stock market, the extent of the impact varies across sectors. According to Fidelity, small-cap and cyclical stocks might benefit the most. Small-cap stocks rely heavily on short-term debt, so lower rates reduce their financial burden. Cyclical stocks, like those in technology, consumer discretionary, real estate, and financials, are sensitive to interest rates and might see improved profitability.

Interest rates and the bond market

Rate cuts directly benefit bonds as bond prices and market interest rates move inversely, meaning that bond prices will rise if bond yields decrease.

However, the effect of Federal Reserve rate cuts on U.S. bond yields is not linear.

According to Morningstar analysts, the Federal Reserve's rate-cutting cycle might begin in 2024, with expectations of the Federal Reserve's rate dropping from 4.85% in 2024 to 1.72%.

Correspondingly, they predict the 10-year U.S. Treasury yield will fall from 3.6% in 2024 to 2.75% in 2027, indicating that the drop in Treasury yields might be less pronounced than the rate cuts.

Interest rates and the gold market

Gold is another asset influenced by interest rates.

Continuous rate hikes in the U.S. have driven up the risk-free rate, attracting capital inflows into the U.S. and boosting the dollar index. Conversely, if the U.S. starts cutting rates, the risk-free rate drops, potentially causing capital outflows and a declining dollar index.

Since gold is priced in dollars, a weaker dollar could drive up gold prices.

However, this is just one factor; gold prices are also affected by its financial, commodity, and safe-haven attributes. Therefore, gold's future trajectory might be harder to predict than bonds.

How to invest in these assets?

Direct investments in U.S. stocks, bonds, and gold might not be very convenient for ordinary investors.

For those with limited investment experience or time, ETFs may provide a straightforward way to track these assets.

Through moomoo's ETF section, investors can easily find ETFs tracking various assets. For example, sectors like technology, consumer discretionary, real estate, and financials might benefit from rate cuts.

Investors can use moomoo's ETF HeatMap feature to find ETFs tracking these sectors.

For instance, in the technology sector, the path is: Markets > ETFs > Heat Map > Sector > Technology.

The largest ETF tracking the technology sector by asset size is the Nasdaq 100 ETF (QQQ), which mainly tracks the Nasdaq 100 Index, including companies like Apple (AAPL), Microsoft (MSFT), and Nvidia (NVDA).

For bonds and gold, investors can also find relevant ETFs through moomoo's ETF section.

To find U.S. Treasuries on moomoo, you can go to Markets > ETFs > Thematic ETFs > U.S. Treasury Bond ETFs.

The largest ETF by asset size tracking U.S. Treasuries is the 20+ Year U.S. Treasury ETF (TLT), which primarily holds U.S. Treasuries with maturities over 20 years. Thus, TLT's price inversely correlates with the 20-year Treasury rate.

Potential risks

Overall, while Federal Reserve rate cuts could positively impact U.S. stocks, bonds, and gold, it does not guarantee that these assets will perform well post-cuts. Several potential risks include:

• Interest rates are just one factor affecting asset prices. Other factors, such as future cash flows for stocks, also play a crucial role. An economic downturn could lower future cash flows, reducing a company's value.

• The market is already highly optimistic about the Federal Reserve cutting rates next year. If the Federal Reserve's cuts fall short of expectations, asset prices might decline.

• The optimistic expectations of rate cuts might already be priced into assets. If the Federal Reserve's rate cuts meet but do not exceed expectations, asset prices might still fall.

Investors should thoroughly assess their financial situation and risk tolerance to develop a suitable investment strategy.

Additional Disclosures: This content is also not a research report and is not intended to serve as the basis for any investment decision. The information contained in this article does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Furthermore, there is no guarantee that any statements, opinions or forecasts provided herein will prove to be correct.