With the Fed managing a soft landing, interest rates may come back down just as quickly as they went up.
Falling rates should help bond prices overall and give investors more reason to come off the sidelines.
Moving out of cash and into short term bonds makes sense though the intermediate term seems more attractive.
After being on hold at 5.5% since July of 2023, the Federal Reserve (Fed) announced a 50 basis point rate cut in the federal funds rate on September 18. The move shows that the Fed is doing its best to stay in front of often conflicting economic releases. In the following article, the Invesco Fixed Income Investment Grade team discusses the current fixed income landscape, and ideas to take advantage of falling rates.
Q: The Fed cut rates by 50 basis points in late September. Did you think the Fed was behind the curve and were you happy to see that number?
We were pleased to see 50 basis late September. We believe the fed funds rate, even at 5% is still restrictive. They don’t want the economy to stumble, so moving 50 basis points gets them heading in the right direction. If they had done 25 and another 25 afterward, it likely would have been too slow of a start. We think it was a good move on their part, as it should reduce the overall tail risk of the economy falling into recession. It is our strong belief that they may continue to cut in 50 basis points increments to stay ahead of the curve.
This past rate hiking cycle was the fastest on record, and we think they will cut just as quickly. We have been adding some credit risk to the portfolios to take advantage of the expectation of lower rates. Not only should the shape of the curve return to normal, but we expect a parallel shift downward as well, which will likely be good for bond prices overall.
Q: If we see six 25 basis point cuts over the next 18 months, that would put the fed funds rate at around 3.50%. How do you think the bond market would react to that?
There are a lot of factors that impact the front end of the yield curve, and generally front-end rates are closely tied to fed funds rates. The long end of the curve is much more closely tied to expectations for the economy. Things like growth and inflation expectations will likely move the middle and longer portions of the yield curve.
We think the Fed has done a great job managing a soft landing, which will likely be good for credit-related asset classes. These asset classes will likely benefit from a re-acceleration of growth sometime next year. We also believe lower volatility will help with returns on agency mortgages.
Q: We have seen money flow out of cash and into bond funds, but there is still a lot of money on the sidelines. Are you surprised to see so much cash still in money market funds?
The uncertainty in the market combined with attractive yields on short-term securities made moving out the yield curve a tough decision. We have been expecting flows to come into investment grade asset classes, but it seems everyone was waiting for an all-clear signal from the Fed. Now that we’ve seen the first cut, we expect to see a lot of that money move into asset classes with some duration.
Q: A lot of investors are worried that they missed the opportunity now that rates are coming down. What do you tell clients? Where on the curve should investors be looking?
We expect the front end of the yield curve to move down, but also expect a parallel shift with the whole curve moving lower.
We think stepping out of cash and into short term bonds is a decent trade, but with the expectation of lower rates going forward, we think the intermediate (5 to 7-year) part of the curve looks more attractive. The important thing is to get some duration on the books while yields are at these levels.
One of the things we pride ourselves on is being agile when the market presents certain opportunities. There will probably be instances when volatility spikes, and we will do our best to take advantage of what the market is offering. That’s the alpha you pay for with an active manager.
With an interest rate cut in the books, here are four reasons why our bond expert believes it may be a time to add tax-exempt muni bonds to a portfolio.
If our soft-landing base case plays out, our investment experts see credit and fixed income opportunities ahead and believe they may be able to achieve high single-digit yearly returns. Read why.
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The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
A basis point is one-hundredth of a percentage point.
Alpha refers to the excess returns of a fund relative to the return of a benchmark index.
The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.
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