Published September 13, 2024
After waiting all year for the Federal Reserve to begin lowering interest rates, the day has finally come when they will do so. Below is Schwab’s take on the Fed’s rationale behind changing their rate policy and how that path might affect the bond market.
“Federal Reserve Chair Jay Powell often employs driving metaphors when talking about how he sees monetary policy. In 2022, he described setting interest rate policy as “driving down a foggy road”—going slowly, to avoid running off the road. More recently, he indicated that the “direction of travel is clear” for interest rates to move lower. However, the pace and magnitude of rate cuts are still to be determined by economic conditions.
The bond market is pricing in the potential for the Fed to take the express lane to much lower interest rates, despite the Fed’s hesitancy in this cycle. Barring a recession, we expect the Fed to maintain a more measured pace. Fast or slow, the important message for investors is that the central bank is exiting its tight policy stance. All roads lead to lower interest rates.
A fork in the road?
In the last six months, conditions have developed that allow the Fed to ease policy. Inflation has fallen, and the labor market has cooled. These satisfy the criteria for the Fed’s dual mandate to maintain price stability while aiming for full employment. The inflation metric that the Fed favors in setting policy, the personal consumption expenditures index excluding food and energy prices, or “core PCE,” has fallen by half, from a peak year-over-year rate of 5.2% in 2022 to 2.6%.
Core PCE has fallen by half from its 2022 peak
Moreover, the leading indicators of inflation are pointing to further declines. Wholesale prices for raw materials such as energy and industrial metals are falling sharply as global demand slows. China’s economic slump has led to a broader slowdown that has spread to Europe and some emerging-market countries. While U.S. gross domestic product (GDP) growth has remained firm in the 2.5% to 3.0% region, global growth is pulling inflation lower.
Wholesale prices have declined sharply from their 2022 peak
A slowdown in employment growth is another factor propelling the Fed toward easing. The pace of job growth has slowed substantially, and the unemployment rate has risen since last year. A rising unemployment rate is a key indicator for the Fed in setting policy. At 4.2% the overall unemployment rate is still low, but the increase from 3.4% is a worrying sign that the economic conditions are deteriorating.
U.S. employment growth has slowed
Will the Fed take the express lane?
With a rate cut at the September 17-18 Federal Open Market Committee (FOMC) meeting a foregone conclusion, the question now is, “How quickly will the Fed move?” The target range for the policy rate—the federal funds rate, which is the rate banks charge each other for overnight loans—is currently set at 5.25% to 5.5% with inflation near 2.5%, leaving plenty of room for the Fed to lower rates.
Inflation is significantly lower than the federal funds target rate
We would argue that the Fed could start the cycle by cutting the fed funds rate by 50 basis points (or 0.5%) and then moderating the speed depending on conditions. However, in past cycles, the Fed has cut rapidly when the economy was in recession or in crisis, such as the pandemic. A fast cycle might be defined as when the Fed cuts five times in a year’s time. That has only happened in recessionary or crisis periods. Currently, the economy is not in recession or crisis, but the Fed is trying to avoid a recession. In cycles when the Fed is cutting in response to falling inflation, the pace has been moderate.
The pace of rate cuts historically has varied
Direction more important than speed
While the pace matters, it’s the direction of travel that is most important for investors. Bond yields are falling and are likely to continue to move lower as the rate-cutting cycle begins. Based on the current structure of the Treasury yield curve, we see more room for short-term rates to fall than long-term rates. The yield spread between two-year Treasuries and 10-year Treasuries has recently moved from steeply inverted to slightly positive.
The yield curve has moved from inverted to slightly positive
While we continue to suggest that investors with a high allocation to cash or short-term bonds should consider extending duration, we would look beyond the Treasury market to do so. We look at the Bloomberg U.S. Aggregate Bond Index as a benchmark. It has a current yield-to-worst (the lowest possible return on a bond with an early-retirement provision, barring default) of 4.2% and a duration of 6.1 years. For most investors, a duration in that region would allow for capturing attractive yields over an intermediate time frame while mitigating volatility.
But we favor staying in higher-credit-quality bonds for the majority of a portfolio. Investment-grade corporate bonds and government agency bonds currently offer yields in the 4.5% region with durations of about six to seven years, which is about 75 to 100 basis points higher than Treasury yields of similar duration.
In addition, investment-grade municipal bonds can offer attractive tax-equivalent yields for investors in high tax brackets. For investors willing to take more risk, a small allocation to preferred securities could make sense, but volatility is likely to be high.
Yields on various bonds may offer more than Treasuries of similar duration
All roads appear to lead to lower rates
With the Federal Reserve and most major central banks in easing mode and treasury yields well above the inflation rate, the direction of travel for rates appears lower. Despite the strong bond market rally over the past few months, we still see room for yields to fall further. This road trip isn’t over yet.
Market Update
After falling sharply last week, investors bought the dip this week. Monday kicked off the week strongly with a +1.2% rise as buyers stepped in. Solid results and the announcement of a partnership with Nvidia fueled software maker Oracle’s shares propelling AI-focused companies anew on Tuesday. That thrust offset weakness in financials on a warning from Ally Financial regarding challenges among their customer base. Further hampering the market was a cut on the global economic growth outlook from OPEC. The oil cartel sees weaker demand which pushed down oil prices -4% Tuesday. The broad stock market still managed a +0.4% lift on the day. A big turning point for the market Wednesday as stocks reversed a morning selloff to close sharply higher in the Nasdaq. The selloff came on a morning inflation report that showed shelter costs continuing to be higher than hoped for. That report initially dashed hopes for a larger 0.5% Fed rate cut next week leading to a drop in stocks. However, almost as quickly, buyers swooped in to bid growth-oriented stocks higher. Nvidia zipped upward by +8% to lead the tech rally. The rally continued Thursday as investors seemed to dismiss the inflation report, noting that shelter costs are a lagging input and that “core” prices continue to meet the Fed’s inflation target. By Friday, the larger 0.5% Fed rate cut was fully back on the table as Fed officials seemed to be talking up the prospect of the move. Stocks added +0.5% Friday on top of Thursday’s +0.8% gain.
By week’s end, the S&P 500 had recouped all of the prior week’s decline posting a +4.01% gain. Same for the Nasdaq with the tech/consumer-heavy index rallying +5.94%. Small cap stocks soared higher Friday to close with a +4.30% weekly tally. After all the hand-wringing on interest rates, the market continued to push rates downward with the 5-year Treasury note falling below 3.5% for the first time in 18 months.
Warm wishes and until next week.