Here Come the Rate Cuts
Co-Author: Kevin E. Strauss, CFA, Partner / Portfolio Manager
The first Fed Funds cut since March 2020 is expected to occur this Wednesday at the Fed’s FOMC meeting. As a reminder, the Federal Reserve quickly cut the Funds rates to zero at the onset of Covid and then held the Fed Funds rates at the zero bound for two years. Subsequently, from March 2022 until July 2023, the Fed raised rates a total of 5.25% to the current range of 5.25%-5.50%. While reductions in the Fed Funds rates are expected over the next year, the market is perhaps getting a bit ahead of itself on the timing. If the economy approaches or enters a recession, numerous additional cuts will happen soon, but if the economy remains stable at a 1-2+% real GDP growth rate the rate cuts will likely occur over a longer time period. The good news is that regardless of the exact pace of Fed rate cuts, we believe a quality, intermediate duration (3-5 years) fixed income portfolio can perform well.
On one end of the duration spectrum, some investors are way too short duration and are “invested” in money market funds, CDs, or very short-dated Treasuries. However, with the period of 5% money market rates quickly coming to an end, it is time for some investors to reassess. Many people are using money markets as an alternative to leaving money in the bank at a much lower interest rate, and this choice is understandable. However, we do not think investors should think of money market funds as an alternative to a fixed income portfolio. Currently, the market is estimating that the Fed Funds rates will be below 3% by August 2025, implying a money market rate of approximately 2.75%. As a reminder, the Fed’s June 12, 2023 Summary of Economic Projections indicates that the Fed Funds rate will decline by approximately 0.75% by the end of 2024, and another 1.5% by the end of 2026. If investors have set duration too short, they will face unattractive rates when it’s time to reinvest those funds. As investors have seen in the past year, very low duration assets do not benefit when interest rates decline, while an intermediate duration portfolio does benefit without taking excessive interest rate risk. For context, the 1-year return on the Intermediate, Investment Grade Corporate Bond Index through Friday is above 10%.
On the other end of the duration spectrum, we are not advocating for locking in rates for 10 or more years. Buying long-term bonds exposes investors to many factors that are more challenging to predict, such as government deficits, the size of the government debt burden, long-term global growth and inflation, and the attractiveness of Treasury rates versus foreign interest rates. Predicting these factors for a decade or more is impossible. Notably, the upcoming November Presidential election has the potential to significantly impact long-term interest rates. In contrast, the Fed controls the Fed Funds rate, which is an overnight rate. The yields on intermediate and long-dated Treasury bonds are only marginally influenced by near-term Fed policy. On the other hand, fiscal policy can heavily influence intermediate and especially longer-term interest rates due to the size of annual government surpluses or deficits as well the level of total government debt. The current betting odds of an all-Republican or all-Democratic sweep is over 50% , but these odds will fluctuate until the results of the November election are known. In the near term, we think the fixed income market would initially view a sweep by either party as inflationary until actual legislation is passed. If no sweep occurs, this would likely be viewed as more of a non-event for long-end Treasury rates. We currently think it is prudent to strictly limit exposure to long-dated rates (10+ years) until we gain further clarity following the election.
Regarding credit spreads, some investors may be tempted to pick up some yield by owning lower quality credits. However, high yield credit spreads are very tight by historical standards, which means investors are getting paid little to take on extra risk. As illustrated in the graph below, now is likely not a prudent time to add substantial credit risk. We continue to find opportunities in high yield, but only because we can be highly selective. Furthermore, we would discourage investors from chasing yield via fixed rate preferreds, as they can be significantly affected by any potential sell-off / risk-off environment. We prefer variable/floating rate preferreds, but we remain discerning as each one has unique terms.
Source: Ice Data Indices, LLC, ICE BofA US High Yield Index Option-Adjusted Spread [BAMLH0A0HYM2], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2, September 13, 2024.
Our approach in fixed income has not changed meaningfully in 2024. We think it is important that portfolios don’t get too short or too long with their duration. Additionally, we would discourage excess risk taking as credit risk spreads are very tight currently. Moreover, conditions change and portfolios need to adapt accordingly. This is why active management is crucial. Owning individual securities within an unconstrained strategy is a key component of ensuring active management can be as flexible as possible.
Reminder: Interest rates on Treasury bonds and the Fed Funds rate are different concepts
Regarding interest rates, investors must remember that interest rates on Treasury bonds and the Fed Funds rate are not the same thing. Interest rates refer to the market-determined yields on U.S. Treasury bonds, which are viewed as risk-free rates, and reflect the cost for the U.S. federal government to borrow at various maturities. The Federal Reserve’s primary policy tool is the Federal Funds Rate, which is the overnight rate at which banks borrow and lend excess reserves. The current Fed Funds target rate is 5.25-5.50% while a 2-year, 5-year, and 10-year Treasury bonds now yields approximately 3.60%, 3.40% and 3.65% respectively. The Fed cutting rates 0.25% or 0.50% next week will not directly impact the 2-year, 5-year and 10-year bond yields.
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