Markets are widely anticipating that the Federal Reserve will begin cutting interest rates — probably by 25 basis points — when the central bank releases its next monetary policy decision on Sept. 18. Another rate cut of similar magnitude is also expected at the following policy release date of Nov. 7.
Interest rates have been frozen at a range of between 5.25% and 5.5% since July 2023 as the central bank has been unwilling to ease rates as they kept a watchful eye on inflation and job data.
Inflation has been gradually cooling down — in July, the annualized CPI figure clocked in at 2.9%, the first time that figure fell below 3% since March 2021. Meanwhile, labor markets are also weakening — the U.S. economy created only 114,000 jobs in July 2024, well below the downwardly revised figure of 179,000 from June.
Expectations for lower rates were also buoyed on Aug. 23 at the annual Jackson Hole, Wyo., summit when Federal Reserve Chair Jerome Powell said that the time has come "for policy to adjust,” while adding that “the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the balance of risks.”
As of the morning of Aug. 27, according to CME Group's FedWatch tool, market participants' pricing of fed fund futures indicated there is a 71.5% probability that the central bank will cut rates by 25 basis points at the next meeting on Sept. 18, and a 28.5% probability it will cut rates by 50 basis points.
Asset managers that Pensions & Investments spoke to generally concur that the Fed will start easing rates later this year, however they vary widely in how they plan to position their portfolios in anticipation of the cuts.
Richard Saperstein, chief investment officer of Treasury Partners, an investment firm based in New York with $12 billion in assets under management, said the impending regime of lower interest rates “provides fuel for equities to move higher.”
At current valuations, he noted stocks are expensive and any further upside will depend on improving earnings. “Abundant liquidity coupled with declining inflation and an accommodative central bank will provide the backdrop for higher stock prices,” he added.
Robert T. Theller, the retirement administrator of the $4 billion City of Fresno (Calif.) Retirement Systems, said that if he was a “betting person,” he would “tactically move in front of tech stocks, mortgage-focused businesses and emerging markets which have been negatively impacted recently and are all interest rate-sensitive.” These asset classes tend to have a history of having “a fast pop” from interest rate cuts.
But as the chief of a very conservatively run pension fund, Theller eschews any allocation moves based on “non-tactical” factors.
“We can't predict exactly when markets will move and statistically it's more likely we would miss than time it exactly,” he said. “We'll keep our long-term, strategic allocations and only adjust methodically instead of jumping into a potential short-term gamble with our retirees and members retirement funds.”
While Christian Hoffmann, head of fixed income at Thornburg Investment Management, agrees the Fed will reduce rates by at least 25 basis points in September, he thinks there’s a risk that markets are pricing in “too many” cuts at this point.
“We nibbled on (risk assets) in early August when volatility spiked, but the opportunities were limited and short-lived,” he said. “We continue to be constructive on duration, but this strong (bond) rally allows you to take some profits.”
Hoffmann added that he continues to expect interest rate volatility going forward.
Thornburg has $44.5 billion in AUM, including $22 billion in global fixed income and municipal bond assets.
“We are reasonably close to home on our duration risk but have a slight short in the belly of the (yield) curve given the extreme pricing of rates cuts implied,” said Gregory Peters, co-chief investment officer of PGIM Fixed Income. “Overall, we are slightly short duration in our funds. The inverted curve continues to allow us to be short and roll up the curve for positive carry.”
PGIM Fixed Income has $805 billion in AUM.
Adam Hetts, global head of multiasset at Janus Henderson Investors, is concerned with maintaining moderate risk. Earlier this year, he said, his firm’s portfolios had “broadened risk” into “more cyclically sensitive areas,” but even in the face of new rate cut optimism sees "a higher bar to significantly increase portfolio risk from here.”
With risk assets having broadly returned to their pre-August conditions, Hetts noted that it was "prudent to maintain the risk we added earlier in the year but are careful to maintain a buffer in case a subsequent growth scare or late cycle slowdown creates a better buying opportunity.”
Janus has $361.4 billion in assets under management.
Saira Malik, head of equities and fixed income and chief investment officer at Nuveen, warned in an Aug. 26 report that more market turbulence may lie ahead.
“This summer’s volatility serves as a reminder to investors that there’s no vacation from diligently monitoring portfolio allocations,” she wrote. “As (economic) data releases continue to highlight the long-discussed deceleration in economic activity, forecasts calling for either hard or soft landings are bound to intensify.”
With a few weeks before the next Fed meeting, Malik noted “there’s still time for (fixed income) investors to add duration and credit exposure to their portfolios if they haven’t already done so.”
Treasury yields at the shorter end of the curve are poised to decline in response to rate cuts, she added, while “longer-maturity yields should come down given a modest slowdown in economic growth — a favorable backdrop for price appreciation in bonds.”
Malik further pointed out that a pivotal presidential election is only a few months away. As such, investors should consider allocating to areas of the market that appear poised for success in a falling rate environment.
“Over the past seven election cycles and across credit sectors, average one-year returns post-election have been strong,” she said.
Within the taxable fixed income space, Malik sees “attractive opportunities” in both investment-grade and below investment-grade categories.
“Preferred securities are a worthy candidate among investment-grade sectors,” she said since they are “underpinned by fundamental strength in U.S. banks — the largest issuers of these securities — all of which passed the Fed’s 2024 stress tests in June.”
As for below-investment grade sectors, she observed that high-yield corporate bonds are yielding over 7%, “particularly compelling in light of how much credit quality has improved in recent years.” Moreover, interest coverage ratios, which are a measure of a company’s ability to service its debt, remain healthy for high-yield issuers, and only a small portion of the debt held by the sector will be maturing in the next few years, she added.
Nuveen has $1.2 trillion in assets under management.
“Slowing inflation, a weakening labor market and the Fed anchoring of the front end (of the yield curve) prompted us to extend duration in the last two months,” said Vishal Khanduja, managing director of Morgan Stanley Investment Management, head of the broad markets fixed income team and a portfolio manager. “Although we believe that the front end is overpricing the Fed’s path, we realize the risks are tilted to the downside. As a result, we are maintaining our overweight to the front end matched by an underweight to the back end of the curve.”
MSIM has $1.5 trillion in AUM.
Tim Tarpening, managing director and portfolio strategist at Pacific Income Advisers, said he is anticipating two, possibly three, 25 bps cuts in 2024. Based on his economic outlook for 2025, he believes the market is underpricing the risk of a resurgence in inflation created by a softer U.S. dollar, growing budgetary and deficit concerns, and either of the new administration’s (Trump or Harris) inflationary spending policies. Therefore, he is overweight in public market credit, continues to have a tilt toward BBB-rated securities and high-yield bonds for his core fixed-income and core plus fixed-income accounts, and the firm's "granular credit analysis has an elevated focus on debt coverage and capital structure."
Tarpening added that he believes the yield curve should continue to “steepen bullishly, but we believe the market continues to underprice the risks of higher longer-term yields.”
Pacific Income has $2 billion in AUM.
