November 2024, From the Field -
After a lengthy wait, the U.S. Federal Reserve began cutting interest rates in September. Many investors may be wondering how this could affect their investment portfolios—particularly their fixed income allocations.
Somewhat surprisingly, the Fed’s first cut pushed longer-term bond yields higher. The yield for the 10-year U.S. Treasury bond rose from 3.65% the day before the Fed’s decision to 3.77% a week later. Shorter-term yields, meanwhile, fell slightly.
This was probably due to the market’s perception of how the U.S. economy could respond to the Fed’s cut. While shorter-term yields are highly dependent on Fed expectations, longer-term yields typically depend more on market expectations for the strength of the economy. Clearly, the markets viewed a 50-basis-point cut as a reason to be more optimistic about the economic outlook.
As a result, bond investors may want to consider the appropriate mix between investment-grade, or IG, bonds and high yield bonds in their portfolios.
Historically, long duration IG bonds tended to be an excellent hedge against economic weakness but less attractive when the economy strengthened. High yield bonds, on the other hand, tended to benefit when the economic outlook improved.
The obvious question is: How have high yield bonds performed after the Fed has embarked on a rate-cutting cycle? A look at the historical record shows that outcomes have been quite mixed.
On average, high yield bonds, as measured by the Bloomberg High Yield Index, returned 4.44% in the 18 months following an initial Fed cut. But the range of outcomes has been very wide.
Not surprisingly, these outcomes depended heavily on whether a recession occurred in periods following the initial cut. In three out of the four instances where a recession did occur during the subsequent 18 months, high yield bonds produced negative double-digit returns.
Following the Fed’s first cut in August 2019, high yield bonds fell sharply once the COVID pandemic hit the U.S. economy six months later—although they bounced back quickly as the recession proved to be deep but very short.
Meanwhile, results for high yield bonds were very encouraging in periods where a Fed cut was not followed by a recession. In all three cases, high yield provided positive returns, most notably during the economic soft landings of the mid-1980s and mid-1990s. However, returns after the 1998 cut were more modest, as the economic outlook remained mixed and a recession eventually did occur in 2001.
An important factor that could provide comfort for high-yield investors now is that credit fundamentals still appear quite strong.
The various metrics used to gauge the health of the high yield market—such as interest coverage ratios, leverage ratios, and cash balances—have deteriorated slightly from their recent peaks but remain high by historical standards. This is typically not the case before the onset of a recession.
Interest coverage ratios are particularly insightful, as they illustrate how much cash flow companies have to cover ongoing interest payments.
As of June, EBITDA, or earnings before interest, taxes, depreciation, and amortization, was almost five times interest costs in the high yield universe—below the recent peak of 5.77, but above the highest level reached from 2008 through 2020. This is still true even if we adjust the EBITDA ratio to account for capital expenditures.
Lastly, high yield bonds currently offer attractive yields—not only relative to other fixed income assets but to equities as well.
One effective way to compare stocks and bonds is to look at the earnings yield for stocks relative to the yield to worst for bonds. Yield to worst is the lowest possible yield on a bond if it is called before maturity. At the end of August, the Bloomberg U.S. High Yield Bond Index offered a yield to worst of 7.3% while the earnings yield for the S&P 500 Index was only 4.7%.
Even if we ignore the impact of the so-called Magnificent Seven technology stocks, which pull the S&P 500 earnings yield lower because of their expensive valuations, high yield bonds now offer considerably more attractive levels of ongoing yield.
We believe the Fed’s recent dovish shift has increased the likelihood that a recession will be avoided over the near to medium term. This has important implications for fixed income portfolios.
If a recession is indeed avoided, high yield bonds may prove more attractive than longer-term investment-grade bonds over the next 18 months. As a result, our Asset Allocation Committee is maintaining an overweight position in high yield bonds.
The U.S. economy appears to have avoided a recession despite one of the sharpest rate hiking cycles ever by the Federal Reserve. Now investors are wondering how strong economic growth will be in 2025.
Thus far, the rebound has been slow and modest, with notable weakness in the manufacturing sector. The Institute for Supply Management’s index of manufacturing conditions remained in contractionary territory at 47.2 as of the end of September.
As a result, company earnings have been broadly disappointing so far in 2024, with the notable exception of companies benefiting from spending on infrastructure for artificial intelligence applications.
One reason for optimism that the pace of growth will quicken in 2025 is the expectation that interest rate cuts by the Fed will drive economic activity higher as falling interest costs boost spending by U.S. consumers.
However, there has only been minimal improvement in interest costs for U.S. consumers thus far. While interest rates on credit cards and new car loans have fallen, they are only about 50 basis points (a half of a percentage point) below their peak levels (Figure 1).
More Fed cuts appear likely, so further relief should be on the way. But it will take some time, and the ultimate magnitude of those cuts is still very much in question.
January 1, 2019, to October 22, 2024.
Source: Bloomberg Finance L.P.
January 1990 to October 2024. Current mortgage rate is as of 10/22/24. Weighted average rate onexisting mortgages is as of 6/30/24.
Sources: U.S. Bureau of Economic Analysis, Federal Home Loan Mortgage Corporation/Haver Analytics.
Meanwhile, rates on fixed rate mortgages are about 135 basis points below their peaks. Mortgage rates are perhaps the most important rates to monitor because the housing market has such a heavy impact on U.S. economic activity.
But the current 30-year fixed mortgage rate, 6.4% as of October 22, is still well above rates on most existing mortgages, currently 3.9% on a weighted average basis (Figure 2). This means that many homeowners are unwilling to sell because they would have to pay a much higher mortgage rate to buy another home.
This raises the question of how much lower mortgage rates will need to go in order to have a significant impact on the housing market.
First quarter 2013 to second quarter 2024.
Sources: Federal Housing Finance Agency/Haver Analytics.
Data from the Federal Housing Finance Agency can help answer this question. Unfortunately, that answer is not very encouraging.
The data suggest it would take a substantial further decline in mortgage rates to make selling financially palatable to most homeowners. As of June 30, only 24.5% of outstanding mortgage loans had rates above 5%, and almost 60% had rates below 4% (Figure 3).
The bottom line is that the impact of Fed cuts is likely to be much more muted than normal given the limited effect they could have on housing activity.
This doesn’t mean Fed cuts will have no impact at all, as rate cuts can affect a wide array of financing activity. But the housing market is typically the most direct way for lower interest rates to translate into a stronger economy. As a result, we believe investors should temper their expectations regarding the economic impact of Fed rate cuts in 2025.
Timothy C. Murray, CFA®
Capital Markets Strategist Multi‑Asset Division
Tim Murray is a capital market strategist in the Multi-Asset Division. Tim is a vice president of T. Rowe Price Associates, Inc.
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