Fed Update – Every Move Has Its Price
This holiday season is a special time for many to gather and reflect on another year gone by. It’s also a critical time for the Federal Reserve (the Fed) as they review key economic data and make their final interest rate policy decision for the year on December 18th. Front and center is the Fed’s dual mandate to promote both maximum employment and stable prices. The Federal Reserve continues to seek the elusive neutral rate – a rate that neither speeds up nor slows down the economy.
So far this year the Federal Reserve has implemented two consecutive interest rate cuts – 50 basis points in September and 25 basis points earlier this month – lowering the target range to 4.50%-4.75%. Fed members chose to cut rates because they determined their past policy was overly restrictive. Additionally, while the unemployment rate remains low, it has been gradually increasing. Supporting their goal of maximum employment combined with lower rates was a major factor leading to the Fed’s November decision.
Since then, the data continues to showcase a resilient economy and normalizing inflation at a 2.6% clip. While inflation is trending downward, it can be a “choppy” path forward – don't expect a smooth, declining graph. The Fed will certainly be monitoring price indexes carefully and may choose to hit the brakes on their easing cycle if inflation shows any signs of resurgence.
Yield Curve Normalizing
Although the Federal Reserve is not on any preset course, the market will always try to predict their next moves. Since the last Fed meeting, we have generally seen medium- and long-term rates rising. Short-term rates, on the other hand, have not risen since the target range has been lowered. These trends inform us that the market is pricing in more inflation and possible economic growth in the future – a healthy and normal phenomenon. This also means that the market expects fewer rate cuts in the future, perhaps due to such a robust economy. We would also interpret the data as supporting our AI, tech-led bull market outlook.
In fact, markets are no longer certain that there will be a cut at the December meeting – currently the market has the odds of a cut fluctuating between a 50-85%. It is likely that the Fed will cut in either December or January, but not necessarily at both meetings which was previously priced in earlier this year.
The uncertainty surrounding Trump’s tariff policy and its potential to stoke the flames of inflation and raise debt levels has also pushed up yields on longer-term bonds as the market compensates long-term investors for this risk and uncertainty. Longer term yields have been trading in a broad range but have still yet to “re-test” their recent highs of around 5%. Nevertheless, the general direction rates of rates have been toward a steepening of the yield curve, suggesting a positive view of the economy and inflation moving forward. The spread between 2-year and 10-year Treasuries is trending in a positive territory after being inverted for nearly two years.
Looking Back, Moving Forward
If we look back year-over-year at the yield curve, we can see some of these factors clearly. The yellow line on the chart below shows us the steeply inverted yield curve during 2023. The green line represents the yield curve today: we can see that on the front end, rates have come down from 5%. This reflects the lowering of the Federal funds rates. On the longer end of the curve –10 years and further out – you can see that rates have dropped in the last year, but not as dramatically.
Source: Bloomberg
Where yields move from here largely depends on how the economy evolves over the coming year. If the Fed continues its rate cutting path, we foresee short-term yields declining further. We expect volatility to remain in long-term rates and can envision them revisiting their highs of 5% if inflation ticks up and economic growth increases dramatically. If economic growth slows and we transition into a period of normalized expansion, we could see yields settling below 4%.
Coupon Clipping – The Benefits of Bonds
Everyone appreciates a good discount or deal, especially during uncertain economic times. We believe bonds can provide value in such periods, as they offer steady and predictable cash flow. In the past bondholders had to physically take their bond coupon payments to the bank to collect them, but that is no longer necessary as technological progress eliminated this errand. However, it’s a helpful reminder of how cash flows work. For instance, if a bond has a 4% coupon rate on a $1,000 face value, the issuer will pay the bondholder $40 annually. So, if you held $40,000 worth of this bond, you would receive $1,600 per year in interest simply by holding the bonds. The interest from all the bond positions in your portfolio add up and work together to provide a steady income stream that can play an important role in supporting your financial plan.
Despite ongoing rate volatility, we still find it attractive to lock in rates above 4%, especially when compared with historical norms. To mitigate interest rate risk, we use a bond “laddering” strategy, ensuring that our bond portfolios have securities maturing at different times throughout the interest rate cycle.
By holding individual bonds, each with a fixed maturity date, we can strategically manage the portfolio as bonds roll down over time. For instance, a 10-year bond we purchased three years ago has now become an intermediate-term, 7-year bond. This approach allows us to gradually rotate out securities and reinvest in new ones that may be more beneficial based on prevailing market conditions.
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 please feel free to share it with your colleagues, family, and friends. Please let us know if you have experienced any changes in your financial situation 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. Wishing you a very happy and healthy holiday season!
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