Manage liquidity as rates peak

For investors with a longer-term time horizon, holding excess cash comes with risks. A balanced portfolio of equities and bonds has historically outperformed cash over most time horizons. And while cash rates are attractive today, it is important to consider reinvestment risks. For example, in our upside scenario, in which inflation falls more quickly than expected, stocks end the year 13% higher, with US 10-year Treasury yields at just 2.5%. If this materializes, investors holding excess cash would have to choose between holding lower-yielding cash or paying a higher price for stocks and long-term bonds—a damaging situation for longer-term wealth growth.

To balance short-term risk and long-term growth, we recommend that investors set aside the resources they need for the next three to five years in a Liquidity* strategy, invested in cash and high-quality bonds, with the remainder of their wealth invested in a diversified portfolio with a focus on long-term appreciation, including assets like stocks, longer-term bonds, and alternatives.

For investors holding cash, or those with upcoming bond maturities, we advise against waiting for the “final rate hike” before locking in current yields. As the negative effects of the interest rate hikes so far become more apparent, we believe markets will increasingly start to price in the possibility of future interest rate cuts.

Markets are already pricing a “pivot” in the Federal Reserve's policy later in 2023. Such a pivot could come sooner if economic growth starts to show weakness, inflation abates faster than expected, or further risks to the financial system emerge. This would make attractive fixed-rate returns on cash and fixed income assets harder to come by in the future.

Rate-cutting cycles have historically been completed over shorter periods than hiking cycles, and in the past two recessions the Fed cut interest rates close to zero, while other central banks cut rates into negative territory. Investors can manage timing risks by progressively locking in yields—averaging into markets and by bond maturity.

Higher interest rates pose a particular challenge for investors with mortgages, portfolio loans, or other debts. All else equal, higher interest rates may require investors to reduce debt balances. But deleveraging should not be an automatic decision. Maintaining sufficient liquidity is important, particularly during times of market stress. And borrowing costs may fall in 2023. In our base case, we expect swap rates, based on which many mortgages are priced, to fall by the end of the year. The market is also expecting central bank rates, the basis for many floating-rate loans, to start declining later this year.

In our view, what is most important is to keep a long-term perspective on both the cost of debt and potential portfolio returns, and to consider debt in the context of an overall wealth plan. In this context, floating rates on debt may now offer better value than locking in currently high fixed rates. Of course, as with all debt, risk is a primary consideration, and investors should only hold as much debt as they are able to service.