Recently the Federal Reserve lowered short-term interest rates for the first time in over a decade, and while the move was widely anticipated, it raised a question in the marketplace as to whether it was just a one-off adjustment to policy or whether it’s the start of a longer-term cycle of interest rate cuts. I’m Kathy Jones and this is Bond Market Today.
When the Federal Reserve lowered its benchmark interest rate, the Fed Funds Rate, by a quarter of one percent recently, the Fed Chair Powell indicated that they viewed it as a mid-cycle adjustment to policy rather than the start of a cycle of more rate cuts to come; and that ran counter to what the marketplace was anticipating. The market had actually built in expectations for two or three more rate cuts over the next year. Now, Powell’s reasoning for the rate cut was the headwinds from the global economy. The global economy slowing down, inflation is drifting lower, and the potential negative feedback from trade conflicts could slow the economy even further.
I would add that there probably were a few other reasons the Fed decided to lower rates. One would be that the yield curve is inverted. Short-term interest rates are above intermediate and long-term interest rates, and that’s often a signal of an impending recession in the next year; and also U.S. interest rates are significantly above those in other major developed countries, and that has driven up the value of the U.S. dollar, which in turn tends to make U.S. exports less competitive and slow the economy.
So, all that being said, though, the Fed’s attitude seems to be that this minor adjustment may be enough to counter those headwinds that the U.S. economy is facing, but the market is very much of the view, still, that we’re going to see further rate cuts down the road.
So, what can investors do with this information now that there’s more uncertainty about the future direction of interest rates? Well, one strategy you might consider is a barbell, and that is holding some short-term bonds and some intermediate-term bonds in the portfolio, and it actually doesn’t have to be weighted fifty-fifty. If you’re more comfortable with more short-term bonds than intermediate-term bonds, it can be weighted differently; but the idea is that with the short-term bonds you have low volatility, if you have high-credit quality bonds like treasuries. So, that low-volatility is an anchor in the portfolio, while the intermediate-term bonds lock in some yield that you could hold on to, should short-term interest rates continue to fall, and again we suggest higher-credit quality bonds, because in an uncertain economic environment, adding credit-risk to the portfolio is only going to create more volatility. So, we like to reduce that by holding higher-credit quality bonds like treasuries and investment-grade bonds.
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