The Fed did it, and may do it again soon

The Federal Reserve started its rate cutting cycle with a 50 basis points (bps) reduction, a larger move than adopted by other top central banks. But Jerome Powell, the Fed chair, said the move reflected a determination to “maintain the strength we currently see” in the US economy, rather than fear of an imminent recession. The decision to kick off monetary easing with a “good strong start,” he added, was possible due to greater confidence that inflation was headed sustainably back to the Fed’s 2% target. The reaction to the Fed’s decision was relatively muted, suggesting investors focused on Powell’s reassurance that the large cut was not due to central bank worries that growth is cooling too abruptly.

Powell’s view that the committee did not see an elevated risk of recession was supported by the latest economic projections:

1. The Fed is expecting the jobless rate to end this year at 4.4%, up from its projection of 4% in June, but still low by historic standards.
2. The projections have unemployment staying low at 4.4% by the end of next year.
3. The median forecast was also for economic growth to remain solid at 2% year-over-year in 4Q24 and at the same pace in each of the following three years.

The dot plot, which charts the rate projections of top Fed officials, implies a further 50 bps of easing in total for the final two meetings of this year, followed by 100 bps in 2025.

Meeting date 18.09.2024

One asset class that will be directly impacted is money markets, as its return potential comes down with short-term interest rates. In six to 12 months, cash-like instruments are expected to deliver much lower future returns.

Implied future cash rates

As potential returns on cash are eroded, we think investors should consider investing cash and money market holdings into longer term fixed income markets, as all-in yields for most fixed income markets are still near multi-year highs. Should yields come down as central banks continue to cut rates, the potential total returns could be considerably more than what the top line yield suggests for those who have duration exposure. Our base case is in line with market consensus, suggesting that there will be a soft-landing for the US, this means credit spreads should remain anchored and provide additional yield pick-up over government bonds.

All-in yields of different fixed income markets

While the “rate-cut train” has not left the station, it is certainly moving. Investors should look to reassess their current positioning to optimize their return potential in the likely approaching scenario of considerably lower interest rates.