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If the Fed Cuts Interest Rates, Will Longer-Term Bond Yields Fall?

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July 24, 2019
Submitted by Site Factory admin on July 24, 2019

Here’s a quick quiz: If the Federal Reserve cuts interest rates, what direction will long-term bond yields take?

If you said “lower,” you’re in good company—but very possibly incorrect. Counter-intuitive as it may sound, rate cuts can actually mean higher bond yields—and lower bond prices—if the market believes the cuts will lead to stronger economic growth and inflation down the road. That can be the case when the first cut of the rate cycle occurs when the economy isn’t in recession.

Markets are projecting a 100% probability of a rate cut at the July 30-31 Federal Open Market Committee meeting, according to the CME Group’s FedWatch Tool, with that cut followed by two to three more rate cuts over the next year. Although the economy appears to be growing at a relatively healthy pace, Fed officials recently have talked about the need for more stimulus to offset the risk that U.S. growth will cool due to trade conflicts and slowing growth abroad.

During his recent congressional testimony, Fed Chair Jerome Powell answered a question about the risks of the labor market running “hot” with the comment, “To call something hot, you need to see some heat.” He pointed out that despite widespread talk about shortages of workers, wages haven’t moved up very much.

Bond market in the middle

Riskier assets responded positively to Fed comments—high-yield corporate bond prices rose and yields dropped. Pundits who were predicting rising yields late last year began calling for 10-year Treasury yields to drop to 1% or even zero.

However, 10-year Treasury yields actually have edged up slightly in recent weeks, as intermediate and long-term yields reacted more strongly to better-than-expected economic data than to comments from the Fed.

Even though the Fed may be about to cut the target for its benchmark short-term rate, the federal funds rate,1 it isn’t necessarily the case that long-term rates will fall by much, if at all. In past cycles, the yield curve has steepened when the Fed has eased policy— sometimes with long-term rates actually moving higher in anticipation of stronger growth and inflation.

10-year Treasury yields and the federal funds rate have diverged before

Source:  Effective Federal Funds Rate, (FEDFUNDS) and 10-Year Treasury Constant Maturity Rate, Percent, Monthly, Not Seasonally Adjusted (DGS10). Data as of 6/30/2019. Past performance is no guarantee of future results.

The disparity between what the Fed is saying and what the economic data indicate leaves the bond market caught in the middle. On the one hand, the prospect of more Fed easing is bullish. On the other hand, if the market believes that the Fed has a shot at boosting inflation, it’s bearish. As longer-term bond yields are the sum of the weighted average of short-term rates plus a risk premium (term premium), lower short-term rates should lower long-term rates.

However, the more likely it is that inflation will actually materialize from the rate cuts, the more the term premium should rise. That potentially results in short- and long-term yields moving in different directions, which is what happened this month. So far, the steepening of the yield curve has been slight, but it may be a hint that the market view of the economy is turning positive.

Rising risks may limit returns

Returns in fixed income have been very strong year to date—anywhere from 2.6% to 12.6%. But with yields low and prices high, those strong returns are unlikely to continue through the second half. Returns through the end of the year are likely to be driven by coupon payments, not further price appreciation.

Year-to-date returns have been strong

Source: Bloomberg, as 7/12/2019. Asset classes are represented by the following indexes: US Aggregate = Bloomberg Barclays U.S. Aggregate Bond Total Return Index; Short-term core = Bloomberg Barclays U.S. Aggregate 1-3 Years Bond Total Return Index; Intermediate-term core = Bloomberg Barclays U.S. Aggregate 5-7 Years Bond Total Return Index; Long-term core = Bloomberg Barclays U.S. Aggregate 10+ Years Bond Total Return Index; Treasuries = Bloomberg Barclays U.S. Treasury Index; TIPS = Bloomberg Barclays U.S. Treasury TIPS Total Return Index; Agencies = Bloomberg Barclays U.S. Agency Bond Total Return Index; Securitized = Bloomberg Barclays U.S. Securitized Bond Total Return Index; Municipals = Bloomberg Barclays Municipal Bond Total Return Index; IG Corporates = Bloomberg Barclays Corporate Bond Total Return Index; HY Corporates = Bloomberg Barclays U.S. High Yield VLI Total Return Index; IG floaters = Bloomberg Barclays US Floating Rate Notes Total Return Index; Bank loans = The S&P/LSTA U.S. Leveraged Loan 100 Index; Preferreds = Merrill Lynch BofA Preferred Stock Total Return Index; Int. developed (x-USD) = Bloomberg Barclays Int'l Developed Bonds (x-USD) Total Return Index; EM = Bloomberg Barclays Emerging Market Bond (USD) Total Return Index. Please see the Important Disclosures section for definitions of indices used. Past performance is no guarantee of future results.

We are particularly concerned about rising risks in the corporate credit markets, including slowing global growth and expectations for slower corporate profit growth. Although credit prices have been supported fairly recently by factors including a corporate tax rate cut, easy financial conditions, plenty of liquid assets on corporate balance sheets, and high investor demand, those factors are beginning to fade. In our view, the greatest risk of falling prices is in the riskier, lower-rated segments of the fixed income market, such as high-yield bonds and bank loans.

What to consider now:

1. Rebalancing: Given strong recent performance, your portfolio may be overweight to fixed income, which can increase your risk if the market should reverse direction. Consider rebalancing—that is, selling some assets that have appreciated and buying others that have lagged—to return your portfolio to its original asset allocation target.

​​​​​​​Rebalancing is especially important if you’ve experienced a big increase in the riskier segments of the markets, like high-yield or emerging-market bonds. At current yield spreads versus Treasuries, valuations for high-yield and EM bonds are high by historical standards, while risks are rising.

2. Reducing exposure to higher-risk assets: Consider reducing exposure to higher-risk assets, like those mentioned above. For investment-grade corporate bonds, we suggest moving up in credit quality, focusing on bonds rated “A” or higher. Given global growth and corporate profit concerns, some (or many) bonds with “BBB” ratings—the lowest rung of investment grade—could be downgraded to sub-investment-grade ratings, which would likely lead to large price declines.

3. Checking your allocation: Make sure your asset allocation matches your risk tolerance and investing time horizon. If you’re not sure how to build a bond portfolio or how to combine stocks and bonds, consider the table below—it shows a Schwab “moderate conservative” model portfolio with a 60% allocation to bonds and cash investments and a 40% allocation to stocks. Your ideal portfolio could be different, but this is one starting point. 

We recommend beginning with a portfolio of investment-grade core bonds and adding riskier bonds, based on your tolerance, to provide diversification and boost potential return. Investors can use Schwab’s Select Lists® to find bond funds in the core and aggressive income categories. If you need assistance, a Schwab Fixed Income Specialist can help.

Sample portfolio using core, international and aggressive income bonds

Source: Schwab Center for Financial Research, based on Schwab model portfolios. The allocation to international bonds and aggressive income would be for investors willing to accept increased volatility in exchange for diversification and potential for higher income. Hypothetical example for illustration only.

 

1 The federal funds rate is the rate banks charge each other for overnight loans.

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