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Change in Fed rate regime means cash is no longer king

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This is a sponsored article from Lord, Abbett & Co., LLC.

The US Federal Reserve (Fed) has signalled an end to a cycle of aggressive rate hikes. Here, we examine the implications for fixed-income investors.

By Kewjin Yuoh, Partner, Portfolio Manager

Market regimes and their transitions can be difficult to observe, but sometimes such turning points become apparent. For example, the Fed meeting of November 2021 brought a recognised pivot by the central bank to a hawkish policy stance wrought by persistent and elevated inflation. And for the subsequent 25 months, this Fed regime was defined by the fastest pace of fed funds rate hikes in history, and a persistent message that the fight against inflation was the Fed’s top priority. We can confirm the hawkish Fed regime ended on December 13, 2023, when projections from Fed officials signalled no rate hikes through 2026 and thereafter.

Throughout 2022 and most of 2023, the pace of increases in the fed funds rate and the resulting impact on the yield curve prompted a shift toward cash and other short-term investments like CDs, US Treasury bills, and money market funds. These vehicles seemed like a safe alternative to high-quality fixed income allocations. The two-year Treasury yield reached its highest level in 2023 (5.22%) on October 18. On that date, the year-to-date return on a basket of one- to three-month T-bills was a respectable 3.98%.1 As of that same date, the year-to-date return on one- to three-year investment-grade corporate bonds (as represented by the ICE BofA 1-3 Year Corporate Index) was lagging at 2.05%.

But with benign inflation prints and the Fed’s dovish pivot, the markets witnessed the potential of performance from duration positioning and credit-risk compensation. In the last 2½ months of 2023, one- to three-year corporates, buoyed by the Fed and the prospect of the inflation fight coming to a close, outperformed one- to three-month T-bills by over 2% and delivered a total return of 5.28%.

This outperformance represents a return to normal. As Figure 1 shows, short-term corporate bonds consistently produce higher returns than three-month T-bills following the last rate increase of a Fed rate-hike cycle. Beyond this immediate period after a hiking cycle, short investment-grade (IG) corporates provide a consistent and reliable excess return to Treasuries. Over the past 20 years, short IG corporates have outperformed T-bills (represented by the ICE BofA US Treasury Bill Index) in 95% of rolling five-year periods (through 31 January 2024).

Figure 1. Short corporates have outperformed three-month Treasury bills after the final hike of previous Fed tightening cycles

Source: Bloomberg. Short-term corporate bonds are represented by the ICE BofA 1-3 Year Corporate Index. Three-month T-bills are represented by the ICE BofA US Treasury Bill Index. The data in the chart summarises returns for periods following the last fed funds rate hike in the previous seven tightening cycles by the US Federal Reserve (1984, 1987, 1989, 1995, 2001, 2007, and 2019). Past performance is not a guarantee of future results.

If we are transitioning to a new Fed policy regime, what might it look like? If the last rate hike has indeed taken place, the outlook for high-quality credit-risk premiums is favourable, as shown. At its 31 January meeting, the Federal Open Market Committee signalled that the fed funds policy rate had likely reached its peak. Since then, the markets have priced in an expectation of approximately five rate cuts in 2024. The total number of rate cuts in 2024 is uncertain – and somewhat unimportant – compared to the Fed actually delivering a cut and beginning a new easing regime.

Figure 2 shows the average movement in Treasury yield for various maturities in the one year (six months before and six months after) surrounding the date of the first rate cut of the last four easing cycles. We have a few observations:

  • While the 10-year Treasury yield does decline, it declines the least in yield, on average, compared to three-month T-bills and the two-year Treasury. It is also our view that yield declines in previous easing cycles were largely driven by expectations of deep recessions correlated with financial crises and pandemics. The 10-year yield should not exhibit significant declines in this cycle due to the resilience and strength of the US economy.
  • The two-year Treasury yield declines, on average, more than the 10-year Treasury yield, i.e., the yield curve steepens. This may provide a tailwind for short-duration assets, leading to superior risk-adjusted returns in the short-duration space.
  • The decline in yield on the two-year Treasury note and three-month T-bill are similar in magnitude over the year. But, for the two-year Treasury, this decline in yield has a positive impact and is a benefit to total return, given the interest-rate exposure. For a three-month T-bill, the decline is a detriment to total return, given the cost of reinvestment at lower yields.

Figure 2. Tracking the path of yields before and after initial Fed rate cuts

Source: Bloomberg. The chart depicts the average path of yields six months before and six months after the first cut in the fed funds rate in 1995, 2001, 2007 and 2019. Past performance is not a guarantee of future results.

Figure 3 shows that short-term corporates outperformed three-month T-bills by an average of 2.43% in the 12 months following the first rate cut over the last seven easing cycles. Duration, interest-rate exposure, and credit risk have been highly volatile in past periods of Fed hawkishness. But in this pause before a potential new regime of Fed dovishness, duration and credit risk will be a tailwind to strong risk-adjusted returns for short-duration, fixed-income opportunities. In a dovish new Fed policy regime, cash is no longer king.

Figure 3. Short corporates outperform T-bills in the 12 months following initial
Fed rate cuts

Source: Bloomberg. Short-term corporate bonds represented by the ICE BofA 1-3 Year Corporate Index. Three-month T-bills represented by the ICE BofA US Treasury Bill Index. Past performance is not a guarantee of future results.

1 All yield and return data presented herein are from Bloomberg.

The value of investments and any income from them are not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested.

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise.

The ICE BofA 1-3 Year US Corporate Index is an unmanaged index comprising US dollar-denominated investment grade corporate debt securities publicly issued in the US domestic market with between one and three years remaining to final maturity.

The ICE BofA US Treasury Bill Index tracks the performance of US dollar-denominated US Treasury Bills publicly issued in the US domestic market. Qualifying securities must have at least one month remaining term to final maturity and a minimum amount outstanding of $1 billion.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

For professional investors only. The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other communications. This does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.

This is a sponsored article from Lord, Abbett & Co., LLC.

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