With the Federal Reserve (Fed) set to meet next week some investment banks have come out ahead of the meeting predicting at least three rounds of rate cuts by January 2020. In light of slower global growth, Morgan Stanley and Deutsche Bank have said in recent reports (see sources below) that their aggressive rate cut predictions are based on the assumption that the Fed will have to react to European Central Bank (ECB) stimulus moves.
In the following article, Daniel Rudnitsky, an income Portfolio Manager, addresses some frequently asked questions about potential rate cuts by the Fed, what impact this could have on investors, and where investors should be allocating their holdings in the fixed income space.
What is the likelihood that the Fed will cut rates three times by January?
Our opinion is that there is 100% chance the Fed will cut rates once, 25%-35% chance twice, and little to no chance they will cut three times by January. Based on the language that we have seen from what Fed officials have been saying in recent speeches is where we are really seeing their hesitancy to cut rates this dramatically. The odds of an October Fed rate cut are very high based on the Fed funds futures market (via the CME FedWatch Tool). The odds are now 94.6%, up from 74.3% last week. The odds that the federal funds rate will be at least 50 basis points (bps) lower by December are now 27.9%, up from 24.1% last week.
What do such drastic rate cuts mean for investors?
Banks and savings institutions are going to feel the pain, and interest rates on savings accounts, CDs, fixed annuities, and short-term bonds are likely to fall. The lower cost of capital could be stimulative, however, a lot of that is already baked into the market. Companies that have significant cash flow and can pay or increase dividends are more attractive in this type of environment. We try to look for long lived assets such as real estate investment trusts (REITS) where the cost of capital is going down. In our estimation a lot of these types of investments are already at fairly full valuations, we could expect to see dividends plus small price appreciation. Within the fixed income space, we would expect that intermediate-term and longer-dated bonds would benefit the most, with a similar scenario of coupon plus a modest price appreciation return.
Considering these forecasted cuts, where should investors be putting their money in the Fixed Income space and why?
We might see a further fall in intermediate-term yields. More aggressive fixed-income asset classes such as high yield will likely respond positively at the outset, expect some price volatility as the cycle matures. As investors consider the relative attractiveness of various fixed-income strategies at this point in the cycle, we advocate for managers that can be duration and credit flexible within their mandate.
Sources: Morgan Stanley Market Pulse, September 16, 2019. “ECB Action Puts Pressure on the Fed”.
Deutsche Bank Research, “The House View,” September 11, 2019.