The Fed has finally kicked off its easing cycle by cutting its benchmark rate for the first time in more than four years, as it attempts to minimize interest rate disruption to the economy. students.
The 50 basis point cut may have surprised many, but we have been reporting for some time that the Fed is well behind in cutting rates. Before the monetary policy decision, the spread between the Fed Funds rate and two-year bonds was the widest in 45 years. The short maturity end of the curve is most sensitive to interest rate movements, and the inversion indicates that the market is expecting deeper declines in the coming months.
The balance of risks has changed
This time around, the reduction was well anticipated after Fed Chairman Jerome Powell said “the time has come for policy to adjust” during his Jackson Hole speech. Mr. Powell’s decision was influenced by new data on the labor market and inflation. The labor market continued to show a slowdown with an increase in the unemployment rate and a more moderate pace of job creation, increasing risks around the maximum employment target. On the other hand, continued progress towards the 2% inflation objective has reduced the risks linked to the price stability objective. This provided a better balance between the Fed’s two statutory objectives, requiring policy adjustment.
As a result, US Treasuries (Bloomberg US Aggregate Treasuries Index) have recouped losses suffered earlier in the year and have posted positive investment returns every month since May.
Good yields on US government bonds after the first interest rate cut
Source: Bloomberg, Jupiter, as at 30.04.24. US Treasuries is Bloomberg Treasuries Index.
Despite the recovery, US Treasuries could still offer good value. The chart above shows that the start of the Fed’s rate reduction cycle bodes well for US government bonds. The chart, which uses data dating back to 1973, shows an upward trend in total investment returns over the three years following the first rate cut in an easing cycle.
While many market participants have already signaled that most of the rise in Treasuries may be behind us, we disagree with such an assessment. Historically, markets tend to underestimate the extent of monetary easing.
In any case, investment grade government bonds and duration exposure seem to us to be attractive hedges at this stage. If the economy were to slow more significantly from now on, the Fed and other central banks could be forced to accelerate the pace of easing, paving the way for further compression of yields. In this scenario, risky assets such as equities or credit could suffer and high-quality bonds could once again offer strong diversification.
We believe that the US jobs market could continue to weaken and that the best days of US consumption could be behind us.
Other economies don’t seem particularly resilient either. The euro zone is showing anemic economic growth and a lack of credit creation, while rising energy prices and competition from China weigh on the industrial sector. China itself is still facing a major real estate crisis and policy support so far seems rather ineffective.
Although recent quarters have been better in the UK, we still see many headwinds, such as the scale of mortgage revaluation and limited fiscal space. Australia recorded its lowest growth in 30 years (excluding COVID) in the second quarter of 2024, while New Zealand’s GDP growth is already in negative territory.
Credit markets: lower exposure, less cyclicality and selectivity
We believe that credit spreads are very low given the risks to growth. This is why, across our portfolios, we have reduced credit exposure in recent quarters.
We prefer to limit exposure to cyclical sectors such as retailers, chemicals and automotive, focusing instead on “through the cycle” companies with tangible assets such as telecommunications and cable networks. Financials, and especially CoCos with a short call date, still offer decent value compared to generic non-financial credit.
The Fed is the latest of the major central banks to begin cutting rates. Others, like the European Central Bank, the Bank of England and the Swiss National Bank, are already on the path to easing. We believe this environment will provide a boost to government bonds, as safety and yields will be important considerations for investors.
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