The waiting game

.

  By Guest Blogger Doug Rowat

.

Does the US Federal Reserve ever just cut rates once and then sit on the fence?

The short answer: never.

Going back some 35 years, the Fed’s easing cycles have looked like this:

• 1989-1994: 23 benchmark overnight-rate cuts
• 1995-1998 (briefly interrupted by 1 rate hike): 6 rate cuts
• 2001-2003: 13 rate cuts
• 2007-2009: 10 rate cut
•  2019-2020: 5 rate cuts

So, while it’s certainly possible that we could have a ‘one and done’ easing scenario, it’s not likely. While the current wait for the Fed’s first cut has so far seemed endless, that first cut is still likely to occur this year, and once it’s under its belt, the runway probably opens up for several more. The CME Group’s Fed Watch Tool currently pegs a 67% chance of a 25 bp cut (or more) at the Fed’s September meeting.

This preamble brings me to the bond market.

As I’ve pointed out before, equities and bonds have been positively correlated for a number of years. The Fed’s 11 rate increases beginning in early 2022 assured that equities and bonds would both fall together, but the potential for rate cuts suggests that they could also rise together as lower rates likely benefit both asset classes.

Equities, of course, have already been moving higher driven by stabilizing inflation and a recovery in US corporate earnings (this earnings season is likely to mark the third straight quarter of positive S&P 500 earnings growth). But bond prices have yet to gain much traction as the reality that we could have higher interest rates for longer than markets initially anticipated is setting in. The 67% chance of a rate cut at the Fed’s September meeting, for instance, once applied to the Fed’s June meeting. Now almost no one expects a rate cut in June.

US 10-year Treasury yields, as a fixed income proxy, have risen more than 70 bps since the start of the year. A few years ago, 0.70% would have been an attractive overall yield for a 10-year Treasury. Now it’s just the y-t-d yield change. So has the reaction of the bond market to possible Fed delays been excessive? Can investors lock in better yields now with the opportunity for further bond price-appreciation once the Fed starts cutting?

If Fed rate hiking is, in fact, over (it’s been about nine months since its last rate increase) and easing is next, it bodes well for bond returns (and equity returns, albeit with much more volatility):

3-year risk-adjusted returns for bonds and equities following last Fed rate hike

Source: Morningstar, Bloomberg, S&P. Bonds represent Bloomberg US Aggregate Bond Index and stocks represent S&P 500. Chart tracks returns following the end of the past seven Fed rate hike cycles.

The timing of rate cuts has, of course, been the million-dollar question for bond investors this year. But, examined more broadly, is the exact timing even relevant? The US 10-year Treasury yield, again as a proxy for all bond yields, is at roughly 17-year highs, so investors are being offered, at least based on recent history, very attractive yields. Assuming you believe Fed interest rate cuts will occur sometime in the next 6-9 months, holding bonds offers not only the present attractive yields but also effectively a free option on the Fed’s interest-rate policy. Future Fed rate cuts will almost certainly bring bond price-appreciation.

Bonds were a disaster for investors in 2022, but since then, even with all the recent Fed-related hand-wringing, they’ve performed reasonably well. The Bloomberg US Aggregate Bond Index, a benchmark of US investment-grade bonds, advanced about 5.5% last year on a total-return basis and is down only about half a percent y-t-d. Not Magnificent 7–level returns, but not terrible.

If you combine the recently more attractive yields with the probability (albeit not the certainty) of Fed rate cuts at some point this year, bonds still offer, in our view, compelling value.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Investment Advisor, Private Client Group, Raymond James Ltd.