Navigating the Fed’s rate-cutting cycle
Bonds continue to offer attractive yields, diversification opportunities and capital appreciation potential, and history suggests it may not be too late in the cycle to increase fixed income allocations.
Bond yields declined during the third quarter, as the Federal Reserve (Fed) embarked on its rate-cutting cycle. Still, yields remain attractive relative to their history, and evidence shows there may still be room to run. The Fed delivered a 50-basis-point (bp) rate cut at the September 18 Federal Open Market Committee (FOMC) meeting, commencing its first rate-cutting cycle in more than five years. This reduction brought the federal funds target rate to 4.75%-5.00%. The members of the FOMC also updated their policy rate projections, known as the “dot plot,” which collectively favored lowering rates another 0.50% by the end of 2024, and an additional 1.00% by the end of 2025. In total, these cuts would bring the policy rate to 3.25%-3.50%. Lower rates generally lead to an easing of financial conditions, so these projected cuts establish a wider runway for a soft landing. With that backdrop, the fixed income and equity markets have done well leading up to, and after, the FOMC meeting (Figure 1).
Figure 1: The Fed’s decision to cut rates provided a boost for stock and bond markets
Equity and fixed income returns: Q3 2024 and YTD
Source: Bloomberg and ICE BofA as of 9/30/24. Indices used: Bloomberg US Aggregate Index, Bloomberg US Treasury Index, Bloomberg US Long Treasury Index, Bloomberg Securitized Index, Bloomberg Municipal Index, Bloomberg US Corporate Index, ICE BofA US Corporate 1-3 Year Index, Bloomberg US Long Corporate Index and Bloomberg US High Yield Index. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell. Past performance provides no guarantee of future results and may not be repeated.
Yields across all major fixed income sectors declined, with the yield on the Bloomberg US Aggregate Index declining from 5.00% at the end of Q2 2024 to 4.23% at the end of Q3 2024. Despite that, compared with their history and relative value versus equities, bonds are still attractive and provide healthy income and diversification benefits, as well as capital appreciation potential (Figure 2).
Figure 2: Bonds offer compelling value relative to their history and equities
Source: Bloomberg and ICE BofA as of 9/30/24. Indices used: Bloomberg US Aggregate Index, Bloomberg US Treasury Index, Bloomberg US Long Treasury Index, Bloomberg Securitized Index, Bloomberg Municipal Index, Bloomberg US Corporate Index, ICE BofA US Corporate 1-3 Year Index, Bloomberg US Long Corporate Index and Bloomberg US High Yield Index. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell. Past performance provides no guarantee of future results and may not be repeated.
While yields often begin to rally even before the first rate cut, history shows the rallies can endure long after the rate reductions begin. In fact, for each rate-cutting cycle dating back to the 1990s, the rallies have continued, on average, for 15 months after the first rate cut (Figure 3). In short, history suggests it is not too late to buy fixed income.
Figure 3: Bond yield rallies have continued, on average, for 15 months after the first rate cut
10-year Treasury yield versus federal funds target rate (in %) with the full Treasury rallies highlighted in blue
Source: Bloomberg, Schroders as of 9/30/24. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell any security or adopt a particular investment strategy. Past performance provides no guarantee of future results and may not be repeated.
Money market fund assets reached a record of $6.42 trillion on September 25, with inflows continuing even after the commencement of the Fed’s rate-cutting cycle. The Treasury yield curve is still inverted at the very front end (0-3 years), a situation that makes money market yields relatively more attractive from a current income perspective. However, with more fed funds rate cuts projected in the coming months, money market yields are likely to fall, and longer-dated fixed income will look more attractive. We can see this as the 2s/10s yield curve has continued to steepen over the past few months (Figure 4). As the curve steepens, long-dated fixed income becomes more attractive than money markets.
Figure 4: The 2s/10s year yield curve has steepened even as money market flows have increased
Money market fund assets vs. 2s/10s yield curve spread
Source: Bloomberg. Current market trends are not a guide to future results and may not lead to favorable investment opportunities.
While current evidence does not show any material repositioning yet, this substantial “wall of cash” could be a potential driver for further strong fixed income performance, as investors look to redeploy their cash investments into positions further out on the curve. Additionally, pension funds have been, and will likely continue to be, a source of flows into fixed income markets. Pensions’ funded status—at 102.4% as of September 30, according to the Milliman 100 Pension Funding Index—suggests that reallocations from equities to fixed income continue to be economical.
The runway to a soft landing has widened but is lined with potholes
In early August, the market caught a bout of risk-off volatility after a disappointing July employment report. The unemployment rate increased by 0.2% to 4.3%, and nonfarm payrolls rose by an underwhelming 114,000. The July numbers were later revised to 89,000, and material downward revisions were also made to the numbers for prior months. Fears that the US economy was starting to deteriorate took hold. However, with more economic data releases since then, the weak July employment report proved to be more an anomaly than a trend. The weekly jobless claims numbers did not spike, and the August employment report showed a rebound in labor with the unemployment rate ticking back down to 4.2%. While reports revealed that inflation has remained sticky, it has been doing so at the relatively benign level of about 3% (Figure 5). The data point to a cooling labor market and economic conditions, but not an economy that is aggressively rolling over. The markets have since recovered from their period of volatility. The S&P 500 Index has been reaching new highs, and credit spreads have reverted to within a few basis points of their year-to-date tights.
Figure 5: Good news on the labor and inflation fronts
Source: Bloomberg and Schroders. 1 – As of as 9/30/24. 2 – As of 8/31/24 for the Core Personal Consumption Expenditures (PCE) Price Index year-over-year comparison versus the Core Consumer Price Index (CPI) year-over-year comparison.
At the September 18 FOMC meeting, Fed Chair Jerome Powell characterized the commencement of the rate-cutting cycle as a “recalibration” of the Fed’s policy focus from fighting inflation to ensuring a soft landing. Leading up to and after the meeting, the US Financial Conditions Index eased to its lowest level since May 2022 (Figure 6), and US mortgage rates have declined to their lowest levels since early 2023. These developments will provide a degree of debt-service relief. That will likely support increased corporate investment and consumer spending, two trends that would then, in turn, mitigate the downside risks for economic growth.
Figure 6: A decline in the US Financial Conditions Index showing looser conditions
Source: Bloomberg as of 9/30/24
According to the Federal Reserve Bank of San Francisco, almost every US recession since 1955—with only one exception—has been preceded by an inverted yield curve. The 2s/10s yield curve had been inverted since July 2022, and only very recently un-inverted. This may be only the second time in more than 60 years that this recession indicator is proven wrong. Currently, the odds of Chairman Powell engineering a soft landing may be in his favor, but the runway is lined with potholes that may add some bumps to that landing. Events looming in the coming months appear to be consequential for the markets, the economy and the world. It is our expectation that financial assets will have a high degree of sensitivity to incoming data and that bouts of volatility will continue.
Escalating tensions in the Middle East
Since the horrific and unprecedented October 7, 2023, attacks by Hamas on Israel, tensions in the Middle East have significantly escalated, and especially so after the killing of Hezbollah leader Hassan Nasrallah in Beirut, Lebanon, on September 28, 2024. Risks of a broader regional conflict, including a direct confrontation between Israel and Iran, have dramatically increased. If the escalation spirals out of control, in addition to the greater human suffering, oil flows from the region could be impacted and that would cause oil prices to spike.
Iran produces about 2 million barrels of crude oil per day, equaling about 2% of global supply. That supply could go offline if Iran’s oil infrastructure is hit. In retaliatory moves, Iranian forces could disrupt the flow of oil through the Strait of Hormuz and thereby create a major chokepoint in the global energy supply chain, given that about 20% of oil consumed globally flows through this vital passage. Rising oil prices could increase production costs for goods, and that would lead to higher prices for consumers, which, in turn, would undermine consumer confidence. Inflationary pressures could also build again, a development that could cause the Fed to slow its pace of rate cuts or even contemplate raising rates again.
US presidential and congressional elections
At the time of this writing, polls from the swing states are not indicating either candidate has a clear advantage in the Electoral College. Prediction markets are giving roughly 50-50 odds for either a Harris or Trump victory in November. The concurrent US congressional elections, which will decide which party controls the House of Representatives and the Senate are consequential, given that they will determine how much of each presidential candidate’s agenda can be implemented.
Over the past several weeks, both campaigns have laid out more concrete economic policy proposals. The Harris plan includes a higher corporate tax rate and increased spending on benefits such as a higher child tax credit and new downpayment assistance for first-time homebuyers. The Trump agenda includes punitive tariffs to reduce the US trade deficit, a lower corporate tax rate, and a lessening of the regulatory burden on corporations. Many of these policy proposals, like the tax policy changes proposed by Vice President Harris, would require congressional approval and therefore need to be considered in the context of all the possible election result permutations. Some initiatives, like the reduced regulations on businesses and the tariffs proposed by the Trump campaign, can be implemented with executive actions that bypass Congress. Reducing burdensome regulations could help propel stronger growth, but higher tariffs could also be inflationary enough for the Fed to slow its current plans for easing or even reverse course and raise rates again. Although both presidential candidates are proposing very different visions for the country, one commonality is that fiscal conservatism has fallen by the wayside. US debt is already 120% of GDP1 and will continue to rise regardless of the election results. This is one of the reasons why we think inflation and bond yields will remain structurally higher in the coming years.
Searching for value across the fixed income universe: Corporate valuations are rich, but opportunities may exist in the securitized market
The corporate credit markets experienced a bout of volatility in August 2024. However, it was very short-lived, and credit spreads ended the quarter tighter than they were at the start of the quarter (Figure 7).
Figure 7: Credit spreads tightened in Q3 and remain well below long-term averages
Source: Schroders, Bloomberg; as of 9/30/24. 1 - The investment-grade (IG) corporate index is the Bloomberg US Corporate Bond Index. 2 - The high yield (HY) corporate index is the Bloomberg US Corporate High Yield Index.
The story for the corporate credit market will sound familiar. On the positive side, credit fundamentals remain supportive, as leverage ratios are stable and interest coverage ratios have increased because of a moderation in the cost of debt. Demand for corporate bonds, which has been the main driver for strong performance year-to-date, remains robust. That strong demand is coming from a diverse buyer base, including yield-hungry insurance and pension investors, retail investors who are putting more money into active funds and ETFs, and foreign investors whose hedging-cost economics are improving with the Fed’s easing policy. While the supply of investment grade corporate credit in 2024 is projected to be the highest it has been since 2020, that considerable volume has been readily absorbed by the insatiable demand from investors.
The negative side for the corporate sector remains valuations, with credit spreads close to their top-decile levels for the past decade (Figure 8). As value investors, this tells us that we are not being well-compensated for taking on excessive spread duration risk. However, with the strong technical and supportive fundamentals for corporates, we have not shied away from owning them when it makes sense. We have been focused on buying shorter-duration corporate bonds when they provide healthy carry with limited spread duration risk. Across the various industry sectors, we continue to favor banks, as their valuations, in our view, have been more compelling than industrials’, and the banks’ capital position remains strong under the increased regulations that came after the Global Financial Crisis. The energy sector is also one that we favor, as companies in the sector have shown improved financial discipline. Increased geopolitical tensions should also put a floor under energy prices, and that development could ultimately benefit the sector.
Figure 8: Credit spreads are near their tightest levels in the past decade
Current percentile of option-adjusted spreads (OAS) for various spread sectors over the past 10 years
Source: Schroders and Bloomberg, as of 9/30/24. Indices used are the Bloomberg US Corporate Index, Bloomberg Corporate High Yield Index, Bloomberg Emerging Markets USD Aggregate Index, Bloomberg US Mortgage-Backed Securities Index, Bloomberg US Aggregate ABS Total Return Index, Bloomberg US Aggregate CMBS Index, ICE BofA US Municipal Index, and the ICE BofA Broad US Taxable Municipal Securities Index. Municipal data uses the AAA municipal yield as a percentage of the 30-year Treasury yield. Security types shown for illustrative purposes only and should not be viewed as investment guidance.
The securitized market, and specifically agency mortgage-backed securities (MBS), is a sector that we believe still offers value. Since 2022, agency MBS has been negatively impacted by the two largest buyers – the Federal Reserve and US banks – stepping away from the market. The Fed had done so because of the shift to Quantitative Tightening, and the banks’ departure stemmed from their shrinking deposit base. Demand from both key buyers has returned, however. Banks have become net buyers once again, and, with the increased flows into fixed income funds, active managers have been reallocating into the sector.
We believe that the improved technical dynamic will be supportive for this sector in the coming months. After lagging the rest of the fixed income market in performance since 2021, valuations for agency MBS have cheapened relative to corporate bonds, and they continue to offer more compensation for risk-taking (Figure 9). Within agency MBS, we favor the more recently issued higher-coupon bonds because of their more attractive valuations, which we believe more than compensate investors for their negative convexity risk. Outside of agency MBS, we continue to invest in AAA-rated consumer asset-backed securities (ABS). With ample credit support in their structure, these have limited credit risk, and they continue to screen cheaply versus corporates with similar durations and ratings.
Figure 9: Current coupon mortgage-backed securities are offering better compensation for risks than corporates
MBS current coupon Z-spread (zero volatility spread) versus corporate spread (in bps)
Source: Schroders, Bloomberg and ICE. Data as of 9/30/24. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell any securities mentioned.
Municipal market offers interesting diversifying opportunities
Tax-exempt municipals cheapened marginally versus the taxable market during the quarter, but valuations are still expensive relative to their longer-term averages. For high-tax-paying clients, we believe there is value in short-term Treasury-collateralized housing bonds, which are offering attractive spreads compared with generic tax-exempt securities. While valuations in the tax-exempt space may appear somewhat expensive, absolute yields remain appealing.
Our focus has also been on the long end of the yield curve, where taxable equivalent yields are particularly attractive for clients with high tax brackets. For instance, the taxable equivalent yield on a recent AAA-rated new issue is 6.5% for investors in the 40.8% tax bracket. That stands in stark contrast to a comparable high-quality corporate bond, which yields about 4.5%. We also think that low-tax clients can benefit from focusing on taxable municipals in the front and intermediate portions of the yield curve, as these bonds have demonstrated greater value compared with tax-exempt municipals on an after-tax basis.
We have also been seeing value in longer-end Alternative Minimum Tax (AMT) airport revenue bonds. These bonds offer a compelling pickup in spread compared with traditional tax-exempt bonds. Across the various sectors within the taxable municipal market, we continue to find Municipal Planned Amortization Class (PAC) Bonds quite attractive. They have a very similar structure and credit profile as agency collateralized mortgage obligations (CMOs), but they offer higher spreads and more stable cashflows. We think that even investors without tax considerations may find these bonds appealing. Municipal credit fundamentals, while weakening marginally, continue to be resilient. In July and August, there were more S&P rating upgrades than downgrades, by a ratio of 1.7 to 1, and we expect this trend will continue into the fourth quarter of 2024.
Conclusion: Fixed income remains attractive, especially with a focus on valuations
The long-awaited Fed rate-cutting cycle has finally commenced. In response, fixed income performed quite well over the third quarter. We believe investing in fixed income will continue to be compelling, given the healthy income, diversification opportunities, and capital appreciation potential this asset class now offers. With the potential for more rate cuts in the coming months, the odds for a soft landing have improved, but tail risks remain. We believe that investing with a value lens continues to make sense. That translates into focusing on assets with valuations that are not stretched and avoiding sectors and securities that are not currently providing adequate compensations for their risks. We remain confident that keeping this mindset will help investors navigate whatever comes ahead.
End notes:
- Source: “Total Public Debt as Percent of Gross Domestic Product,” as of 9/26/24 update, Federal Reserve Bank of St. Louis
Any reference to regions/ countries/ sectors/ stocks/ securities is for illustrative purposes only and not a recommendation to buy or sell any financial instruments or adopt a specific investment strategy.
Interested to read more investment insights? Click here.
Subscribe to our Insights
Visit our preference centre to select the types of insights or events you would like to receive
Important Information:
This document is issued by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders). It is intended solely for wholesale clients (as defined under the Corporations Act 2001 (Cth)) and is not suitable for distribution to retail clients. This document does not contain and should not be taken as containing any financial product advice or financial product recommendations. This document does not take into consideration any recipient’s objectives, financial situation or needs. Before making any decision relating to a Schroders fund, you should obtain and read a copy of the product disclosure statement available at www.schroders.com.au or other relevant disclosure document for that fund and consider the appropriateness of the fund to your objectives, financial situation and needs. You should also refer to the target market determination for the fund at www.schroders.com.au. All investments carry risk, and the repayment of capital and performance in any of the funds named in this document are not guaranteed by Schroders or any company in the Schroders Group. The material contained in this document is not intended to provide, and should not be relied on for accounting, legal or tax advice. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this document. To the maximum extent permitted by law, Schroders, every company in the Schroders plc group, and their respective directors, officers, employees, consultants and agents exclude all liability (however arising) for any direct or indirect loss or damage that may be suffered by the recipient or any other person in connection with this document. Opinions, estimates and projections contained in this document reflect the opinions of the authors as at the date of this document and are subject to change without notice. “Forward-looking” information, such as forecasts or projections, are not guarantees of any future performance and there is no assurance that any forecast or projection will be realised. Past performance is not a reliable indicator of future performance. All references to securities, sectors, regions and/or countries are made for illustrative purposes only and are not to be construed as recommendations to buy, sell or hold. Telephone calls and other electronic communications with Schroders representatives may be recorded.
Topics