Why now could be the time to transition from cash to bonds
The recent bond market rally—fueled by a cooling U.S. labor market and dovish commentary from Federal Reserve (Fed) Chair Jerome Powell—has left many of our clients wondering if they’ve missed the opportunity to move out of cash and lock in longer-term yields. The short answer: No. Rates seem to be trending lower, and this trend may be just starting.
On September 18, the Fed cut policy rates by 50 basis points (bps). Less than a week earlier, the European Central Bank lowered its policy rate by 25 bps for the second time in three months. We anticipate additional 25-basis-point cuts at each subsequent Fed meeting until the first half of 2025, when the pace should slow. In short, the U.S. rate-cutting cycle is underway. History tells us that bonds typically outperform cash during these periods.
What might this mean for investor portfolios? Certain investors may consider a move from cash into longer-dated, fixed income securities to potentially capture future price appreciation (as bond yields fall, prices rise).
The power of duration and diversification
In the language of fixed income professionals, we think it’s a good time to extend duration. As a reminder, duration is a measure of a bond portfolio’s sensitivity to changes in interest rates. Extending a portfolio’s duration before rates decline causes the market value of the underlying securities to appreciate as future cash flows are discounted to a lesser extent. In other words, you need duration to benefit from falling rates. Without it, you’ll receive only coupon income from your bonds, a fraction of the total return potential in fixed income.
A strategy we recommend investors to consider is a full-duration position of five to six years, which can be achieved through various investment options, such as a 1–17 year bond ladder or mutual fund. Consider holding duration in a diversified portfolio of high-quality credit or municipal bonds. We don’t expect credit spreads to widen from current levels, and the credit premium (the extra yield over a risk-free bond) contributes valuable income, potentially boosting the total return.
This is not the first time we’ve made the case for extending duration. At various times over the past two years, we have recommended considering this approach. But this still seems a possibly opportune moment.
Looking at the forward curve of expected Treasury yields, a six-month Treasury bill currently yielding 4.74% is expected to yield only 2.88% in September 2025 and 2.82% in September 2026 as the Fed cuts rates. Based on market expectations, an investor rolling six-month Treasury bills over the next 30 months would experience a return of 3.31%. Instead, we recommend locking in yield in a longer-duration security today. For example, the AAA 5-Year Muni Index yields 2.41% or 4.07% tax-equivalent yield, accounting for the tax-exempt status of muni income.
Expected six-month Treasury bill and AAA 5-year muni index yields
How the Fed might be reading macro data
As always, thinking about fixed income means thinking about the Fed. Some investors worry that the Fed might be “behind the curve” in cutting rates. In their view, the weak jobs report suggests that the central bank should have cut rates at its mid-July meeting. We think the Fed looks comfortably on track to shift into a rate-cutting cycle beginning in September.
Briefly, here is why the Fed believes its March 2022–July 2023 rate hikes (the fastest hiking cycle in 40 years) has tamed inflation and cooled the economy enough to cut rates:
- Lower core inflation. Core PCE inflation, the Fed’s preferred metric, has dropped from 3.7% in August 2023 to 2.6% in June 2024. Significantly, inflation rates for primary rents and owners’ equivalent rents, which have been among the stickier components of the index, have declined significantly.
- Higher unemployment. Unemployment has climbed 80 bps from last July to 4.3% today. According to the Sahm Rule, historically when the three-month average of the unemployment rate rose by 0.5 percentage points or more relative to its 12-month low point, a recession was underway. As of July 2024, the three-month average was up 0.43%, signaling an increased risk of recession.
We do think the U.S. economy is cooling, but we assign just a 25% chance of recession over the next 12 months (up from a 20% probability in July). Remember: If the economic growth environment does deteriorate, bonds can help mitigate risks to your overall portfolio.
Seize the opportunity—it may be fleeting
Our call to consider extending duration in advance of Fed rate cuts is particularly relevant for clients who retreated into cash during the 2022–2023 rate-hiking cycle. They have been earning a 5%-plus risk-free yield for over a year. Certainly holding cash helped protect fixed income portfolios from price depreciation during the hiking cycle.
But reinvestment risk is real—those risk-free yields won’t likely last. By remaining in cash, clients could miss what could potentially be in our view the most significant driver of fixed income returns since 2007. One sign the cycle is turning: Since July 1, the Bloomberg U.S. Aggregate Bond Index has returned 3.58% compared with a 0.54% return from a three-month Treasury bill index.2
You can find duration opportunities across investment grade credit, municipal bonds and government bonds. Think hard about locking in today’s yields—wait too long and they might be gone.
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