What Lower Rates Could Mean for Your Stock Returns

Source: Avantis® Investors

Learn how U.S. stocks have responded to changing interest rates, with insights from Avantis® Investors’ research focused on the 10-year Treasury yield.

Declining interest rates are generally positive for bond returns. All else being equal, as bond yields go down, their prices go up. Many are familiar with this relationship, but what about stocks? Can declining interest rates inform our expectations for future stock returns?

This question has come into focus for many investors after the Federal Reserve (Fed) decided to cut the federal funds rate by a quarter-point at its September meeting. It was the first rate cut from the Fed since late 2024, and it lowered the effective Fed funds rate from 4.33% to 4.08%.

More cuts are widely expected going forward, but the pace and magnitude are debated.

Figure 1 shows two key sources for future rate expectations: the current median projection from the Fed’s Board of Governors and expectations implied by prices in the fed funds futures market.

By the end of 2025, the Fed and the market expect similar rate cuts—two more quarter-point reductions. After that, their forecasts differ: the market expects two more cuts in early 2026, lowering the rate to 3%, while the Fed only projects one cut in 2026 and another in 2027. This shows agreement on the direction of rates, but not on the timing.

So, what do falling rates mean for stocks? According to asset pricing theory, stocks benefit if rates fall more than the market expects. If rates fall less than expected, stock returns may be lower. Thus, market expectations are as important as the actual rate changes.

To explore this, Avantis® Investors analyzed how U.S. stocks performed in different interest rate environments, focusing on the 10-year Treasury yield. They compared average monthly returns from 1973 to 2024 during years when rates fell by more than 1%, stayed about the same, or rose by more than 1%.

Results show that U.S. stocks have generally done better when rates dropped sharply, likely due to lower borrowing costs and higher present values for future earnings. However, the data isn’t conclusive—stocks have also performed well when rates rose, and positive returns occurred in all scenarios.

In Figure 2 Panel B, we add perspective on small-cap stocks. Some believe that small-caps are expected to do better than the market when rates are declining and suffer disproportionately when rates are rising.

To investigate, Avantis® Investors examined two segments of the U.S. small-cap market: small companies with low prices to their book equity (P/B) and small companies with both low P/B and higher levels of profitability. The data highlights two key points:

1. Small-cap stocks with low P/B outperformed the overall market when rates fell sharply but also did well when rates rose. Both types of small-cap portfolios delivered higher average returns than the market in all interest rate environments.
2. The difference in returns between the two small-cap groups is significant, suggesting that considering both price and company fundamentals (like cash flow) can further improve results.

Avantis® Investors also analyzed stock performance across entire interest rate cycles, some lasting less than a year and others much longer. Figure 3 shows the 10-year Treasury yield over our sample period, with vertical lines indicating rate peaks and troughs.

Avantis® Investors compute returns for the same portfolios from their first experiment, but this time during the interest rate cycles, which correspond to the peaks and troughs from Figure 3. Results in Figure 4 Panel A cover the full peak-to-trough (falling rates) and trough-to-peak (rising rates) periods. Panel B splits each into halves to assess whether we see different outcomes early or later within rate cycles.

This analysis gives Avantis® Investors many more data points to evaluate how stocks have historically performed in relation to what’s happening with interest rates. Still, Avantis® Investors came away with takeaways similar to those from our first experiment

Avantis® Investors sees slightly higher average monthly returns for the U.S. market during declining rate cycles compared to returns in other periods, but the differences aren’t significant, and the data is inconclusive.

Again, regardless of the rate environment Avantis® Investors finds higher-than-market average returns from small-cap stocks with low price-to-book ratios and even greater outperformance from small-cap stocks with both low price-to-book ratios and high profits¹.

What Really Matters

While this analysis provides useful context for investors, it should not be used as a tool for market timing. All results are based on hindsight, and future rate changes remain uncertain. What matters most for stock returns is not just the direction of rates, but how actual changes compare to market expectations.

The key takeaway is that, historically, the market has performed well for investors regardless of whether rates rose or fell. Predicting rate movements was not necessary for positive returns. Additionally, focusing on company fundamentals—such as price and cash flows—has consistently made a difference, no matter the interest rate environment.