Powell adds to rate-cut caution

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US Federal Reserve Chair Jerome Powell warned on Tuesday that interest rates may need to stay higher for longer, following a series of stronger-than-expected inflation reports. Chair Powell backed away from providing guidance on when interest rates may be cut, saying that “it’s likely to take longer than expected” to achieve the confidence required for policymakers. “Right now, given the strength of the labor market and progress on inflation so far, it’s appropriate to allow restrictive policy further time to work and let the data and the evolving outlook guide us,” he said.

His comments caused investors to further dial back the likely pace of rate cuts, with markets now implying just 40 basis points of easing during 2024. That is down from a peak of around 150 basis points in January. The yield on the 10-year US Treasury climbed 5 basis points to 4.66%, the highest level since early November. The S&P 500 fell another 0.2%, taking its loss this week to 1.4%. That puts the index on track for its third consecutive weekly decline.

While we have recently lowered our expectations on the timing and magnitude of Fed rate cuts, we believe the US central bank remains on track to cut rates twice this year, most likely starting at its September meeting. This means the return outlook for quality bonds remains positive and attractive, and that recent losses in fixed income are likely to be temporary.

The Fed remains biased toward policy easing. As Powell suggested, the US central bank believes the current rates are in restrictive territory, and they continue to transmit into the economy and put downward pressure on demand, despite taking longer than expected. If the Fed should raise rates from here, which is not our base case, that would compromise its objective of achieving full employment and stable inflation. Up until this point, the Fed has managed to achieve a delicate balance in seeing inflation trending lower without generating a recession. A restart of rate hikes would put this in jeopardy and potentially stoke financial stress across the corporate and household sector, in our view. In addition, we believe the downward trend in inflation will resume as restrictive monetary policy helps cool consumer spending and the labor market.

Yields on quality bonds look attractive and there's still room for capital gains. With rate cuts delayed, rather than canceled, in our view, we still expect the yield on the 10-year US Treasury to end the year around 3.85%, down from around 4.66% at present. As a result, we continue to see the potential for capital gains. Once the Fed begins cutting rates this year, the bond market will likely continue to price a sequence of further cuts into 2025 and beyond. Currently, the market’s longer-term policy rate expectations suggest the Fed will end the rate-cutting cycle at an equilibrium level of just under 4%, which equates to around 150 basis points of easing overall.

The disinflationary trend in much of the rest of the world reinforces our constructive view on quality bonds. The UK consumer price index for March dropped to the lowest level since September 2021, following recent encouraging trends in Switzerland, the Eurozone, and Canada. In addition, European Central Bank President Christine Lagarde this week said policymakers are “heading toward a moment where [they] have to moderate the restrictive monetary policy,” confirming the ECB is moving closer to a cut in June, after the Swiss National Bank’s first move last month. While the divergence between the US economy and other advanced, open economies is apparent at the moment, inflation over a longer time horizon in these markets tends to correlate.

So, we believe investing in quality bonds remains a viable option, and retain a most preferred rating on the asset class in our global portfolios. We like those with 1–10-year duration, as well as sustainable bonds. We also think investors should consider an active exposure to fixed income to improve diversification.