Time To Start Preparing For Rate Cuts

Time To Start Preparing For Rate Cuts
From Donald Ellenberger, Senior Portfolio Manager and Head of Yield Curve Committee at Federated Hermes

This month’s slightly cooler U.S. inflation report likely won’t give the Federal Reserve enough confidence to cut interest rates soon, but should it postpone the duration extension trade for fixed-income investors? The futures market now expects the Fed to deliver as few as one quarter-point reduction of the fed funds target range this year. Investors considering moving assets to bonds might conclude they should put those plans on hold. After all, money market and stable value yields remain north of the Bloomberg Aggregate Bond Index. But while timing the movement in interest rates isn’t any easier than timing the stock market, fixed-income investors have bond math on their side. Let me explain.

Duration is related to the maturity of a bond. The longer it takes to get your principal back, the more sensitive the bond’s price is to changes in interest rates. Bonds with longer maturities will go up in price more than bonds with shorter maturities if rates fall. That’s why many investors wonder if it’s time to extend duration to benefit from a potential decline in interest rates. Of course, extending duration too early can lead to price depreciation. But with interest rates significantly higher today than they have been for much of the past 15 years, this risk is much more muted than when the federal funds level was lower.

Also read: Five Forces Reshaping Fixed Income Markets

The Fed may not be ready to cut rates until late in the year given stubborn inflation prints to start the year, it likely won’t raise them again. And once inflation falls further, which we believe will be the case, so too should rates and bond yields. That should lead to price appreciation that complements coupon cutting. Exactly when that happens matters less than preparing for it by starting to extend the duration of a bond portfolio.