The markets have had another strong run so far this year through the end of September. Expectations of interest rate cuts by the Federal Reserve pushed both stocks and bonds higher over the summer. Stocks tumbled in August after some softness in US economic data. Investors were trying to determine what a Federal Reserve cutting cycle would look like with a labor market that has been slowing. The S&P 500 is up about 22% year-to-date. Large cap stocks have outperformed this year with technology continuing to lead the way.
The Federal Reserve lowered interest rates in September by a half point (50 basis points) amid signs that inflation is moderating, and the labor market is cooling. This was the first interest rate cut since the early days of the pandemic in March 2020. The Fed also indicated that that there would be further rate reductions by the end of 2024 with additional cuts in 2025 and 2026. The federal funds rate sets short-term borrowing costs for banks which then impacts things like mortgage, auto, and credit card interest rates. It’ll likely take some time and additional cuts to see noticeable reductions in these rates.
Yields had declined this summer with the expectation that the Federal Reserve would be cutting interest rates. Bonds prices have moved higher as they move inversely with yields. Core bonds, as measured by the Bloomberg US Aggregate Bond Index, are up about 4.5% for the year. Bonds have made a comeback as portfolio diversifiers and helped to provide stability when volatility has picked up. Despite the drop in yields, bonds remain attractive and could see further price appreciation if rates drop further. Ongoing trends in inflation and the employment situation will determine the future path of rate cuts and the pace.
As rates decline, it’s likely that we’ll see lower yields on cash equivalents including money market funds and CDs. We’ve been talking with clients this year about the benefits of extending duration (going further out in terms of maturities) on the fixed income side of portfolios to take advantage of the higher current yields that have been available. This could also mean potential price appreciation in bonds (bond prices rise as yields fall). We think it makes sense to slowly extend duration and lock in rates for longer periods of time with excess cash on the sidelines. Reinvestment risk (being unable to reinvest CDs and bonds at the same rate they are currently paying) rises as interest rates move lower. Historically, bonds have outperformed cash during previous Fed rate cutting cycles.
There’s been some softening in recent economic data for consumers, but not a collapse, as the US economy has remained resilient. Inflation is moderating, the corporate earnings environment remains healthy, and the Fed has entered a period of interest rate cuts to stimulate economic activity. Lower interest rates should translate into lower borrowing costs for consumers and corporations over time. The stock market may remain volatile in the near term with uncertainty about the upcoming election and how it may impact future policy changes. Historically, the fourth quarter is the best quarter in terms of performance of the year. A recession does not appear likely in the short-term.
Historically, markets have performed well under both parties and investment decisions shouldn’t be based on which party is in office. Focusing on the long term and sticking with your asset allocation that’s built around your goals and risk tolerance is much more important.
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