Short-term markets during rate cuts

Inflation and the labor market now appear to fit the Federal Reserve requirements for a rate cut. But with only three Federal Open Market Committee (FOMC) meetings left this year, it isn't a question of if policymakers will ease in 2024, but when and by how much. The markets are currently predicting a cut at each remaining meeting, some of the 50 basis-point variety. Our Short Term Investments Committee (STIC) is predicting the first cut to be a quarter-point cut arriving in September, though August data could adjust our opinion and sentiment is building for a 50 basis-point cut among some committee members.

All predictions aside, it might be more helpful to talk about the impact this guessing game is having on short-term markets and what we expect whenever the easing begins. Treasury yields have already dropped substantially in anticipation of policy change. For example, the 2-year Treasury was over 5% in April-just four months ago-and is now near 4%. At this level, the market is projecting about 300 basis points of cuts over the next two years as, in theory, the 2-year Treasury yield is the average of the federal funds rate over the next two years plus a term premium. When rates drop, fixed-rate bonds move up in price which can contribute to price appreciation within short-duration investments. Longer-duration securities typically increase more than shorter-duration securities. So, we carefully consider "duration management" when making investment decisions because it can substantially impact relative performance compared to a benchmark, especially during periods of interest-rate volatility. As of late, we have seen attractive relative value in AAA-rated asset-backed securities, which are outyielding A-rated corporates and in some cases BBB-rated corporates. Mortgage-backed securities issued by Agencies such as Freddie Mac also can provide good relative value considering their attractive spreads above Treasuries.

When the FOMC does cut the target range of the federal funds rate, we expect the Secured Overnight Financing Rate (SOFR) to decrease in lockstep. Floating-rate notes, which are primarily indexed to SOFR, will follow. What does this mean for investments across the short end? Well, distribution yields will likely dip. Liquidity yields should drop faster than short-term bond yields. Direct security yields will probably adjust the fastest due to their shorter nature. This mismatch in the change of rates could lead to a normalization where we eventually see bond yields above money markets, and potentially well above direct securities and bank deposits. How much rates are cut, i.e., 25 or 50 basis points at a time, will impact how quickly and dramatically the normalization comes into being.

In that environment, we anticipate investors will transition out of direct securities and FDIC insured bank deposits into potentially higher yielding money market investments. Additionally, we could see those who can, move out further into short-duration investments to capture even higher potential yields. While this trend likely won't be seen broadly until the first cut occurs, I can't claim to know when and by how much we will see these changes either. I will say this, though, in the guessing game with the Fed, markets tend to move earlier. When the time comes, investors may wish that they too had proactively adjusted their investments to capture any additional benefits possible prior to official policy changes.