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Fed Easing Changes the Game for Fixed Income Investors
Summary:
The Fed does not condition its rate forecasts on recession, but rather on a view that real GDP growth and inflation will both be trending near 2%.
The Fed chose to end the monumental suspense over “25 or 50” basis points for its first rate cut of the easing cycle with the more decisive action. Wisely, it chose not to make us wait all year for a “meager 25.”
Whatever the Fed’s decision, further declines in US policy rates have always been just a matter of time. Is the Fed uncertainty all out of the way now? The Fed’s decisiveness actually left markets less clear in some respects. Short-term fixed income markets are now roughly split 50/50 on the chance of 25 or 50 basis point rate cuts at both the November and December FOMC meetings. The “25 or 50” agony will continue.
By the end of next year, fixed income markets now price cuts in the Fed funds rate from a peak of 5.5% all the way down to 3.0% (this represents the “top end” of the Fed’s target range).
Of course, Treasury yields could still move lower, particularly when equities and credit markets weaken. This is why we believe investors should consider allocating at least a portion of their investment portfolio to Treasury securities as a core holding to provide some “ballast” should the economy unexpectedly weaken.
Portfolio considerations
Fixed income investors need to shift their focus to wisely managing credit risks. There are standout yields still available across the risk spectrum ranging from government-backed mortgage securities to high yield loans. We believe diversified portfolios should not exclude US Treasuries even as yields have moved decisively lower. But Treasury Bills in isolation are not a portfolio.
Fed Policy Rate Likely to Fall to 3.4% by end-2025
As it seeks to engineer a full normalization and “soft landing” of the US economy, this past Wednesday the FOMC cut the Fed Funds rate by 50bps, taking the rate down to 5%. This was the first rate cut since the pandemic shock of 2020. The FOMC also published its “dot plot,” an estimate of where the Fed thinks the Fed Funds rate might be in the next few years. While this dot plot often proves inaccurate, it does provide a window into the Fed’s current expectations. For now, the Fed is indicating the possibility of six more 25bps rate cuts through the end of 2025, down to a top Fed Funds rate of 3.50%. In 2026, the Fed indicates the possibility of another few cuts, down to about 3%. Futures markets are slightly more aggressive on the pace of Fed rate cuts but not really the depth. The market currently prices nearly 2% of cuts down to 3% in 2025, with perhaps one more cut after that to 2.75% in 2026.
When looking at both the Fed’s dot pot and the futures market, they both coalesce around an ultimate “neutral rate” of about 2.75-3% for Fed Funds at some point in late 2025 or early 2026. The US Treasury market has already priced in much of this potential shift in yields lower, so since the time of the Fed’s previous dot plot back in mid-June, the yield curve has declined considerably. Most of the decline has occurred in the “intermediate” portion of the yield curve (2-7 years), an area we have long favored for investors. The 2y yield, for example, has declined by more than 100bps, while 5y yields have declined almost 80bps and the 10y has dropped by about 50bps.
A US Recession May Impact Rates Further
Of course, the more important question for most investors is what the Fed will achieve. The Fed’s growth and inflation forecasts are steady and have barely changed. In line with updates to data since June, the unemployment rate forecast is a tad higher. But the Fed has roughly doubled the speed of its expected rate cuts. This is far closer to bond market pricing than the Fed’s previous forecast and closer to historic experience.
While we indeed expect the US labor market to continue slowing, it’s most notable that output data continue to remain firm. On a year/year basis, US real GDP growth exceeded 3% in 1H 2024 and tracking data suggest a roughly 2.5% pace this quarter. Strong labor markets didn’t mean strong corporate profits in 2023. Similarly, a slower labor market hasn’t inhibited a broadening profits recovery in 2024.
O/Ws Continue for Equities
Meanwhile, US policy is a critical question for the world. As this past week showed, the Fed has moved decisively in a more friendly direction for global asset prices. Foreign policy, US fiscal policy, and tariff policy could be a different story. There, the question is “how disruptive might US policy be?”
These questions weighed on our Global Investment Committee as we held our allocations steady this week. We maintained overweights in equities centered in US “broadening strategies” aimed at softening tech concentration risk. In the long run, we will need to carefully assess any changes in the drivers of US outperformance, which has been profound in the past 15 years. Potential policies of the upcoming US administration could potentially shock, strengthen, or weaken that trend.
We’ve also maintained overweights in US bonds while underweighting global bonds given the US yield advantage. Even so, the declines in US Treasury yields across all maturities represents a new investor challenge. It requires us to focus on segments of the bond market where yields have remained high on a risk-adjusted basis.
But we think investors may benefit from differentiated types of credit in the core fixed income portion of their investment portfolio (depending on their knowledge of the products, their risk tolerance, and other suitability factors). Based on our view that real GDP growth this year and next will be around 2.4%, we estimate that credit spreads – the return one can earn over Treasury yields – will remain relatively range-bound.
We believe investors should therefore consider intermediate maturity investment grade corporate bonds as a core fixed income holding. Credit spreads remain very tight, declining from about 150bps a year ago to about 80bps currently. While this spread is not particularly high relative to historical levels, it is still incremental yield in addition to Treasury yields and should provide some additional income.
To stay updated on all economic events of today, please check out our Economic calendar
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