Market Expectations for Rate Cuts Have Changed: Now What?

Bond Concepts by Madison Investments

When the July jobs report signaled a slowing economy, the bond market was convinced that the Federal Reserve (Fed) would act soon and act big to reverse tight financial conditions. The market rapidly priced in over 100 basis points of cuts to the fed funds rate by the end of 2024. Bonds repriced across the yield curve, and volatility in stock and bond markets spiked, leaving many investors asking, “Now what?”

Bonds vs. Cash

Whether market expectations for rate cuts are again too lofty or we really are headed for an aggressive cutting cycle, one thing is certain: when the Fed starts cutting rates, investors stand to lose the 5%-plus interest rate they are earning on cash. While cash (such as money market funds, high-yield savings accounts, and short CDs) may be labeled a “risk-free” asset, we think investors should consider two important risks when choosing cash over bonds: duration (interest rate risk) and reinvestment risk.

Duration

Duration is a measure of the expected change in a bond’s price for a given change in yields. When interest rates rise, duration becomes a tangible measure of a bond’s decrease in value. However, duration also offers the potential for capital appreciation. When interest rates fall, the price of a bond increases, leading to capital gains for investors should they decide to sell the bond before maturity. The greater the duration, the greater the price appreciation (falling rates) or depreciation (rising rates).

While yields across maturities will not all fall at the same rate (some may even rise while others fall), a normalizing yield curve typically offers capital appreciation potential at various maturities. Cash, however, has a duration of zero and cannot offer price appreciation when rates fall.

Reinvestment Risk

For investors who reinvest interest and principal payments, reinvestment risk is another important concept to consider. Such reinvestments will earn whatever the market dictates as the going rate. As rates fall, maturing bonds with higher yields are replaced with lower-yielding bonds, reducing income. Conversely, as rates rise, a portfolio’s income increases as low-yielding bonds are replaced with higher-yielding ones. Reinvestment risk is a function of interest rate volatility and the maturity structure of the underlying investment.

With longer-term bonds, investors are exposed to less reinvestment risk in return for taking on the interest rate risk (duration). With cash or other short-term investments, an investor takes very little interest rate risk but is exposed to extreme reinvestment risk.

Every investor’s time horizon is different. But if the Fed is to be believed and the market’s expectations are correct, the most likely path for rates over the next 12-24 months is lower. When the Fed cuts rates and the yield curve normalizes, cash will likely meaningfully underyield a portfolio of intermediate bonds at today’s yield.

Bloomberg Intermediate Gov Credit Index vs Fed Funds

Final Thoughts

1. Consider locking in yields ahead of Fed cuts

As of this writing, longer-term bond yields have dropped from their highs, as the bond market largely expects an aggressive Fed-cutting campaign to end 2024. Still, yields are higher than much of the past 15 years. Barring another bout of high inflation, the window to lock in these yields may be closing.

2. Market timing is a risky strategy

Timing the move from cash to longer-term bonds can be challenging and risky, especially for investors with low-risk tolerances that rely on income and stability. When the yield curve normalizes, interest rates may have already fallen significantly, and the investor could be left earning less income than if they had locked in the longer-term rates sooner.

3. Fixed income offers diversification from riskier assets

In addition to its role as a source of safe income, many invest in fixed income to hedge against riskier asset classes in their overall asset allocation. While cash will not lose money if the economy falters (though yields will likely plummet when you need them most), it will also not grow in value, offsetting losses elsewhere. At current levels, bonds offer positive, inflation-adjusted cash flows and the potential for capital appreciation should the economy slow and rates fall.