As summer drifts into fall, we expect a change not only in the seasons, but also in monetary policy! This September is likely to be one to remember as the Federal reserve will likely make its first interest rate cut this cycle. At their annual meeting in Jackson Hole, Fed chair Jerome Powell announced the "direction of travel" is clear and the time has come for the Fed to begin easing rates.
This “change of the seasons” will mark the end of the interest rate hiking cycle that started in March of 2022. Since then, the Fed raised rates multiple times to 5.25-5.50% and has kept rates steady at these levels since September 2023 to beat inflation. Now that inflation has come down to a more manageable level, the focus is no longer on cooling the economy, but on supporting growth and the labor market through lower interest rates, which should entice more economic activity. This would be a welcome relief to many as it will make borrowing costs cheaper and help ease concerns that high rates are suppressing economic activity. This change in policy also benefits our fixed income strategy – as you may remember we have been purchasing bonds with longer maturity dates, which will experience price appreciation from a decrease in interest rates. Because of this “teeter-totter” relationship, these longer duration bonds will trade a higher premium the further that interest rates fall overtime.
Market Pricing of Interest Rates
The timing and pace of easing likely will be gradual as the Fed assesses the risks of keeping policy to restrictive (which could hurt the economy) or easing too much (which could allow inflation to resurface). The market has already been eagerly pricing in rate cuts. Traders are currently pricing in 3-4 cuts this year – at least one cut at each of the three remaining meetings this year.
This is down from the six rates cuts being priced in at the beginning of the year and up from one being priced in May. The market repricing of rate cuts over the course of the year has caused treasury yields to fluctuate dramatically. We expect this trend to continue over the course of the next year as rate cut probabilities can change based on incoming economic data.
We have seen short-, medium-, and long-term rates decline in recent weeks in reaction to economic data and Fed outlook. The yield on the 2-year treasury, which is the most sensitive to fed rate expectations, retreated and touch below 4%. The high rates we have witnessed with short term treasury yields above 5% and longer-term rates above 4.50% are likely to stay in the rear-view mirror as the fed lowers rates.
A dynamic interest rate environment
We anticipate that as the Fed lowers interest rates, the yield curve will eventually steepen, meaning short-term yields will decrease more significantly than long-term yields. This adjustment should help normalize the yield curve, which is welcome news for investors after two years of inversion. We have seen signs of this occurring in recent weeks, as the spread between the 2-year and 10-year treasuries are trending toward positive. A normal yield curve is a positive economic sign as it usually indicates a stable or growing economy and can suggest that investors expect steady growth and moderate inflation. This can also be a very productive environment for stocks.
With recent declines in rates and the Fed's anticipated cuts, reinvestment risk is becoming a pressing concern. Investors with large concentrations of money invested in short-term holdings –such as money market funds - may face the challenge of reinvesting or finding the similar opportunities with lower rates. To mitigate this risk, we advocate for laddering portfolios with a focus on intermediate and long-term bonds. This strategy helps lock in stable income streams over extended periods and can enhance the overall return of your investments. Historically, during the past five interest rate cycles, bonds with intermediate maturities have outperformed short-term investments, which is another potential benefit to our approach. If you have outside assets that are sitting idle in a bank account, or money market fund, this is a great time to speak with your Advisor about different alternatives. The time is now.
We expect rate fluctuations to continue as the Fed’s path is still being outlined and can change based on economic conditions. While rates have declined recently, they remain at elevated levels when viewed from a historical perspective. Our expertise in credit research, custom bond ladders, and tactical rotation allows us to offer tailored solutions to help you stay aligned with your financial goals.
We hope this Fixed Income Update is helpful, and feel free to share it with your colleagues, family, and friends. Please let us know if you have experienced any changes in your finances or have questions about your portfolio.
If you have a friend or family member who would be interested in a no-cost portfolio review, please let us know.
Thank you again for your continued vote of confidence in our work.
Watch the video strategy update:
Listen to the audio version of this article:
Disclosures: Main Street Research LLC (“MSR”) is an SEC registered investment adviser; however, this does not imply any level of skill or training, and no inference of such should be made. The opinions expressed herein are as of the date of publication and are provided for informational purposes only. Content will not be updated after publication and should not be considered current after the publication date. We provide historical content for transparency purposes only. All opinions are subject to change without notice and, due to changes in the market or economic conditions, may not necessarily come to pass. Mention of a security should not be considered a recommendation or solicitation to purchase or sell the security, and any securities mentioned may be held by MSR for client portfolios. The information posted represents an opinion as of the date published and should not be considered an investment recommendation. MSR does not become a fiduciary to any reader or other person or entity by the person’s use of or access to the material. The reader assumes the responsibility of evaluating the merits and risks associated with the use of any information or other content and for any decisions based on such content. Investment disclosure —neither the information nor any opinion expressed herein constitutes a solicitation by main street of the purchase or sale of any securities or other financial instruments nor a recommendation to hold, sell, buy, or own a particular security or sector in your portfolio and do not represent all securities purchased, sold or recommended for client accounts. The listener should not assume that an investment in these securities has been or will be profitable. Individual recommendations are tailored to individual portfolios. Main street client portfolios are managed separately and vary in regard to risk and return dependent upon individual client circumstances. A full list of all securities in the MSR client portfolio is available upon request. No-cost wealth planning is a part of our fee-only wealth management services. For additional disclosures, please click the link in footer. Disclosures: https://bit.ly/3TCc78H