Mark Harries, Square Mile’s Chief Investment Officer, provides an overview of the impact of the Federal Reserve’s recent 50bps cut in interest rates on fixed income markets. Key points to consider include:
· Over recent years, elevated interest rates following the Fed’s aggressive rate-hiking cycle have created significant challenges for fixed income investors.
· With stubbornly high inflation and a surprisingly resilient labour market in the US, the Fed had little option other than maintain its hawkish monetary policy.
· This stance now seems to be reversing with a slowing economy perceived to be a greater risk than inflation. While it is impossible to predict with certainty the future trajectory of interest rates, this first cut might be indicative of further cuts in the coming months.
· The recent rate cut could be a turning point for fixed income investors, who have dealt with challenging, volatile market conditions for several years.
· This has kept yields and coupons high, but has supressed bond prices, making capital appreciation harder to achieve.
· Falling interest rates, in the US as elsewhere, should lead to rising bond prices, meaning that 2025 may be the year that see bondholders start to enjoy capital returns.
· Nonetheless, it is important to remain alert to short term noise surrounding news flow and the dangers of making misinformed decisions as a reaction.
· A long-term focus is essential, as well as focussing on quality issuers that can weather any economic backdrop.
“The news that the Federal Reserve (the Fed) cut its interest rate by 50bps has meant one of the most anticipated monetary policy shifts has finally arrived. Prior to the Fed’s announcement, it was unclear if the committee would make a more cautious 25bps cut or go ahead with a 50bps reduction, which many believed was required to prevent a more severe slowdown in the economy.
“The size of the cut aside, this recent development at least signals a pivotal moment for markets as a whole. So far this year, the Fed had decided against lowering rates due to continued stronger-than-anticipated economic data and inflation staying higher for longer. However, with weakening labour market numbers and the belief that inflation is sustainably moving towards its target, the Fed’s committee members felt it was the right time to switch its stance to one of looser monetary policy.
“So, given rate cuts are usually warmly received by markets, what does that mean for fixed income investors specifically? Is it a certainty that, after years of challenging market dynamics, it is finally fixed income’s chance to shine?
The market backdrop
“There is no denying that the last two years have been tough for fixed income investors.
“The inflation experienced in 2022, coupled with the aggressive monetary policy that followed from central banks (including the Fed) created an incredibly difficult backdrop. Furthermore, volatility has continued to characterise the markets too which has been exacerbated by investors expecting a rate cut far sooner than September 2024.
“In fact, interest rates remaining elevated following the Fed’s aggressive rate-hiking cycle, has been one of the biggest issues for investors. Arguably, though, rates had to remain higher as inflation proved to be stubborn and resisted tightening measures made by the Fed. The Fed was, therefore, forced to continue its hawkish stance as the U.S. labour markets remained surprisingly resilient, while inflation stayed above target levels.
“The result? While higher yields led to higher coupons, higher rates also suppressed bond prices meaning capital growth was hard to achieve.
The pivot point
“Now, the pendulum seems to have swung for policymakers. The risk for the Fed is no longer inflation, but a slowing economy. The rate cut could, therefore, be the key to unlocking returns many bondholders have been waiting for as when interest rates fall, bond yields typically decline as well, pushing bond prices higher. For those holding existing bonds, this is particularly beneficial as the value of their bonds rise in response to lower yields in the broader market.
“Additionally, after so much anticipation of a rate cut, the Fed’s decision finally to move away from its hawkish stance gives clearer insight to the future. While there is always uncertainty in the market, it seems more likely now that investors can at least count on further rate cuts, which is supportive of bond prices.
“More opportunities could also become attractive across several different types of bond funds. For instance, we currently prefer investment grade credit over government bonds, given the economic outlook is favourable for company earnings. However, our stronger preference remains in strategic bond funds. These are run by fixed income managers that our research team have identified as having both the skill set and flexibility to move into different types of bonds depending on the current environment. Doing so allows them to take advantage of all the opportunities the asset class has to offer.
Square Mile’s outlook for bonds
“For many, the news of a rate cut should be promising—especially for bondholders, given the rollercoaster ride of the last two years for fixed-income investors. Bonds won’t just be used to mitigate risk in equities; they could also generate returns in themselves.
“That being said, it’s vital to stay vigilant to risks too. After all, the Fed has cut its rate by more than many assumed, in response to weak economic data. Being flexible and taking a diversified approach will be essential to navigating any further tricky periods, as well as adjusting interest rate risk as required by market conditions.
“Taking a considered, long-term view of the markets, therefore, remains essential. Square Mile’s philosophy is built upon the view that using a long-term outlook is central to generating long-term returns. There will undoubtedly be a great deal of short-term noise as a result of the rate cut and its size, but reacting to the news flow can result in misinformed decisions.
“Finally, our long-term view means we actively seek out quality. We believe it is essential to invest in companies that can weather any economic backdrop – be it with interest rates decreasing or a higher rate environment. We focus on finding quality issuers to try and ensure we avoid any defaults. As and when further interest rate cuts occur, then, they should be a positive contributor to portfolio returns.”
