When the Fed Begins to Cut Rates, All Roads Lead to Fixed Income
Fed Cuts Favor Fixed Income
The Fed has joined the global easing cycle marking an important moment for financial markets and for investors. In our view, the direction of US monetary policy is clear—US interest rates will continue to head lower over the coming quarters. As rate cuts occur, history suggests the bond market is where investors should want to be. Diversified exposure to fixed income assets has outperformed allocations to cash-like instruments in the last ten Fed easing cycles since 1984. However, we acknowledge easing cycles can be unpredictable, with bumps along the way.
Source: Morningstar and Goldman Sachs Asset Management. The analysis takes into account ten Fed cutting cycles starting in 1984: four of which were associated with recessions (1990, 2001, 2007, 2020), three of which were associated with growth scares (1987, 1998, 2019), and three of which were associated with normalization (1984, 1989, 1995) . Abbreviations: 3-month US T-Bill: 3-Month portion of the Bellwethers U.S. Treasury Index, US Agg: Bloomberg US Aggregate Index, IG Corporate: Bloomberg US Corporate Investment Grade Index, HY Corporate: Bloomberg US High Yield Corporate Index, IG Muni: Bloomberg Municipal Bond Index, Global Agg: Bloomberg Global Aggregate Index. Bloomberg Global Aggregate returns are based on cycles after 1989 due to data availability. Past performance does not predict future returns and does not guarantee future results, which may vary.
Over the past four decades, US rate cuts have been accompanied by either a growth scare, recession, or normalization. In each scenario, intermediate duration fixed income has delivered positive absolute returns. Strategies with duration delivered the strongest returns in recession / growth scare environments. In past episodes where growth normalized and recession was avoided, returns have shown considerable dispersion.
We maintain our view that the US economy is still on course for a soft landing and see opportunities to capitalize on current yields and the dispersion among spread sectors through actively managed fixed income strategies. Given the record $6.5 trillion sitting in money market funds today, we believe it is time for investors to determine their next steps away from cash.
Hoist Your Sail When the Wind is Fair
As inflation risks diminish and central banks look to normalize policy to manage growth risks, fixed income provides a powerful tool–providing income, stability, and the potential for capital appreciation as yields fall. With a dynamic of bond market yields being historically attractive and valuations amongst spread sectors showing dispersion, an active approach to fixed income investing is prudent for investors to navigate both challenges and opportunities which may arise during the easing cycle.
By employing thoughtful asset allocation and identifying repeatable alpha and selection opportunities, we believe fixed income investors can generally outperform index-based strategies. In our view, today is a strong environment for active management. Among Global Core Bond strategies, 74% of active funds outperform the median passive strategy over trailing 5-year periods. Within multi-sector bond, the number of strategies beating passive index strategies is even greater at 94% of the time.
Source: Morningstar, Goldman Sachs Asset Management. As of September 30, 2024.
Today’s Environment, Tomorrow’s Potential Returns
In our view, fixed income investors can capitalize on the Fed’s easing cycle and changing macro conditions by considering the following strategies:
If you’re parking dry powder in cash, reinvestment risks will increase as the Fed eases policy, increasing the allure of longer-duration higher yielding strategies. Given the attractive asymmetry of returns, we believe investors should consider allocating more to fixed income than they have in the past.
As interest rates decline—and the potential for growth shocks increases— high-quality intermediate duration offers a structural benefit to portfolios. Moreover, as inflation risks have receded, we think high-quality bonds offer a more normalized negative correlation to risk assets. The kicker? Yields on core bonds remain at near 10-year highs!
An active multi-sector approach to income investing is a powerful diversifier to core bond positions. With the economy still showing resilience and on a path toward a soft landing, we do not believe it’s the right time to avoid or underweight credit exposure. Instead, we believe investors remain selective and focus on liquidity, particularly within lower-rated segments of the market.
Municipal bonds (munis) offer attractive income on an absolute and tax-equivalent basis versus history. Specifically, we see value in mid-to-lower rated municipal credit supported by favorable fundamentals and strong technicals.
Securing a Strategic Advantage
The Fed’s arrival to the easing cycle bodes well for bonds. More broadly, we believe fixed income allocations provide a strategic advantage to portfolios. With elevated yields relative to history and dispersion amongst credit sectors, it’s an opportune time to take an active approach to fixed income investing.