The Federal Reserve Cut Interest Rates. What Should We Do Now?
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David d's dying today is episode four ninety five is title the federal serve cut rates. What happens now? Last week, the federal reserve open market committee reduced its policy rate by a half a percentage point. The new range is four point seven, five percent to five percent.

Now IT was all but certain that the fed would lower its policy rate, but what was a toasting b was whether the cut would be a bold half a percent or a more modest quarter of a percent. The chAllenge with a half percentage point reduction is IT could signal that the federal reserve felt IT was behind in reducing its possible rate. That economy was slowing more significantly.

Then what the fed was comfortable with, I shared in our inside guide newsletter last week, the day of the cut that in the past twenty five years, when the federal err began reducing its policy rate as part of a monetary easing cycle, when IT reduced IT by a half a percent, the U. S. Economy always entered into a recession.

Now there were three times two thousand one, two thousand seven and twenty twenty. Conversely, though, when the federal reserve started off and continued with quarter percentage points cuts each and every time, the three times that occurred, one hundred and ninety five, nineteen, ninety eight and twenty and twenty, avoided a recession. The one exception was one thousand nine ninety.

The federal reserve started with a quarter percentage point cut and then followed with three half a percentage points cuts. When U. S. Economy entered into a recession, the fed started with a half of percent, pl said.

As inflation has declined and the labor market has called, the upside risks to inflation have diminished and the downside risk to employment have increased, we now see the risk to achieving our employment and inflation goals is roughly imbaLance, and we are attended to the risk to both sides of our dorMandy. The flood reserve has a dow Mandate full employment while keeping inflation under a control. Later in his press conference, pal said, I don't see anything in the economy right now that suggests the likelihood of a downturn is elevated.

In fact, in their statement, the first line of the federal open market committee statement released a week ago says recent indicators suggest that economic activity has continued to expand at a solid pace. The federal reserve expects an economic soft landing. Their updated economic forecasts that were also released last week confirms this soft landing expectation that or not enter into a recession, that you'll be a gradual slowdown of the economy.

But IT will avoid contraction in GDP power in his press conference said, we are not on any preset course. We will continue to make our decisions meeting by meetings. why? Because the federal reserve open market committee, the participants and federal reserve chair pal, they don't know what's going to happen.

They don't know whether inflation will continue to come down. They expected to. They don't know if the economy will hold or enter into recession.

They don't expect you to expect the economy to continue to expand a solid pace. So where will interest rates go from here? The most probable scenario is interest rates will continue to decline as the feed reserve reduces its policy rate.

There are three primary drivers that determine interest rates. The first is the expectation for future short term. Iterate the central bank policy rate.

The expectation is that the policy rate will fall, and provide us some more details on that in a minute. The second driver is inflation expectations. What do market participants believe inflation rates are going to be in the future?

The third element is the term premium, additional compensation investors to main for uncertainty regarding inflation and what central banks will do. The term premium also captures the impact of supply and demands on bonds. Let's look at each of of of the three elements in more detail to see where we are currently.

The first is the expectation for future short term interest rates. There is A A tool that a link to. It's the C M.

E. Fed watch too. And IT is expectations the federal serve policy rate based on what's Price in to the futures market. Based on that bond market participants anticipate the feed reserve will continue to reduce its policy rate by march twenty twenty five. The expectation is that it'll be below four percent currently, the range is four point seven, five percent to five percent.

The majority over half believe that the polis rate will be less than three and a half percent in october twenty twenty five. The expectation based on what's in the futures market is that policy rate will be between two and hf percent in three point two five percent. That polar is equivalent to what investors will earn investing in cash equivalence be a money market, mutual funds or treasury bills.

Now the federal serve open market committee, their expectation for the policy rate twenty twenty five is IT will be between three point one and three point six percent and the range is between two point nine and four point one percent. So they're not expecting cuts as deep as what's Priced in to the futures market. Now we have to remember though that the feed open market committee as well as financial market participants are not very good at forecasting what the policy rate will be.

I'll link to a piece and economist that I shared earlier this year, and IT shows the policy rate over time. And then IT compares IT to the expectations of bomar participants. And the lines are all over the place.

The expectations invariably participants doesn't think pilot rates would get as high as they got, and they expect them to fall faster than they have. We don't know. We know what IT is now four point seven, five to five percent.

That's the kind of yields we continue to get on. Cash expectation is IT will gradually fall, but IT depends on the other two factors, one being inflation. Before we continue, let me POS and share some words to one of this week.

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So higher professionals like a professional on linked in post your job for free at linton dot comes last, David. That's linked in that comes last, David, to post your job for free, terms and conditions apply. What are inflation expectations? We can look at that by comparing the yield on nominal treasury bonds to the real yield on treasury inflation protection security.

Right now, the yellow on ten year treasury ies nominal three point seven five percent, the real yield on ten tips is one point five eight percent, and the difference is the inflation expectation two point one seven percent. If we do the same calculation for five year nominal treasuries and tips, the inflation expectation is to point of four percent. That's what's Price the bond market.

Now again, the bond market isn't great at predicting interest rate. Let's go back five years, August twenty nineteen. The real yield on five year tips was zero, and the nominal yield on five year treasury bonds was one point four percent.

The market expectation for inflation was the difference, one point four percent inflation expectation on the average over the five years from twenty nineteen August through August twenty twenty four, the real inflation rate was four point two percent. Over those five year period, the market was up by two point eight percent. So we've to recognize, yeah, we know when inflation expectations are.

But one reason we buy treasure inflation protection security is to benefit from unexpected inflation. And had an investor bought a series eye saving pod back in two and nineteen or a tips, they would have been Better off because they got that inflation protection and inflation came in higher than what was anticipated by market participants. The third element then is the term premium, the additional compensation investors demand on that front.

The term premium currently is close to zero. It's been much higher in the past one and a half, two percent. Another is after factory in short term rate expectations and expected inflation, there been times that boniest have been an additional one and a half percent higher.

Now additional compensation is zero, and that is one reason i'm not overly bullish and going out and buying long term bonds because there is no additional buffer protection, uncase inflation is higher than expected or in case policy, rates don't come down as fast as the market expects. So we don't really know what interest rates will do. And that's why earlier this year in epo de four sixty three and four sixty four, we had a number of episodes on how to lock in higher yields in case interest rates fall.

We anticipated rates would fall as the federal serve would start to reduce this policy rate we want or but we looked at bullet T, F, individual bonds, cds, fix unities and zero coupon bonds as a way to lock in higher integrates. And many listeners did, many plus members did. I know I did.

And so we've locked in some yield. In the meantime, we're continuing to get very attractive fields on cash back in epsom four eighteen and in other episodes that up. So was a bond investing master class came out in generate twenty twenty three.

I said a rule of for a body T F mutrie und in terms of its expected return is the starting ulto maturity starting at the maturity being basically that that expectation. How is the bond Priced currently based on prevAiling interest rates, the coupon rate on the bond. And there is a mathematical formula that comes up with a yield to maturity, which is estimated return of holding that bond until maturity.

I'll link to a paper that I shared back in August twenty twenty three by J. P. Morgan. And they basically say the same thing. They they count IT. As a rule of thumb, they write as a rule of thun, I fixed come folia is often expected to deliver analyze return similar to its starting yelm mature over the duration of the portfolio, not accounting for active management.

In other words, D, F, A bond portfolio has a six year duration, which duration being the measure of its interest rate sensitivity, and will talk a little bit more about donation later in the episode. But if the duration is is six, then the expectation is that. Over a six year period analyzed return of that bond portfolio would be at starting ultimatums.

And in their paper, they went back to ninety, seventy six and they looked at the starting yield. And the when six year analyzed return and IT was generally close within a percent or two. IT was an exact but it's it's a rule of fun. There's a caveat here and I admitted lately have set this wrong in the past because this is how I was taught in studying finance as an undergrad.

And in graduate school there's a quote from a textbook my body says, to maturity is the standard measure of the total rate of return of the bond over its life body continues yet to maturity will equal the rate to return realized over the life of the bond. If all cupid ds are reinvested, add an interest rate equal to the bonds yelled to maturity. I have said that an episode that if you invest in a bond, T, F, IT has a starting yield maturity of five percent, and you hold IT for seven to eight years, that in order to get that analysts return to five percent, that the interest payments received, the diving is need to be reinvested at a rated return of at least five percent.

That is a correct statement, but that doesn't mean that the casualness have to be reinvested. In other words, a year to maturity isn't dependent on reinvesting the cash flows that will happen no matter what that just the elite material in the bond, the cash as could be spent and the in the yield to maturity, the rate return will still be five percent. The way to think about this is if you had a burker account and I had and there was one bond etf, let's say B N D, the vanguard total bond market etf and IT pays a dividend, I think monthly if you're gonna measure the total return of your portfolio and if we wanted to equal the starting yet to maturity because you have those coupon payments now on that account, they do need debri invested at least to earn the starting of the maturity.

That just kind of basic math. But the bond etf itself is onna do what IT does. IT will earn IT starting the maturity you are respective what the investors do with the coupon payments.

One of the things that I want to do. So J. P. Morgan did IT.

They looked at a starting yield to maturity and then looked at the subsequent six year return. I wanted to do IT for different band indexes in different periods of time. We used to not have the data to be able to do that.

IT was locked away by bloomberg and other providers this morning as a record. This, we released bond market research tools to asa camp. Asa camps are research platform to analyze the stock market and now the bond market.

I've been trying to get access to these type of tools for decades since i've been an investment adviser to be able to get an understanding of the long term return of the twenty eight bloomberg bond indexes that we cover, global, U. S, europe, asia and emerging markets. We now, and you, as an asset camp, subscribe, have access to over three hundred bond market and metrics covering twenty eight bond indexes.

We have the ability to analyze the yellow curve. We can look at you to maturity over time relative to its average. We can look at the spread incremental build for credit, corporate bonds, mortgage back securities.

We can look at the valuation of bonds related the stocks, and we can look at the expected or return. We can model expect returns for different bonds based on different scenario for interest rates over time. I can tell you how excited we are.

They have this. And so i'm using this tool as we prepare this episode. And you can try for free and get seven days free. Try how you get access to everything. We have all thirteen hundred charts for the stock and bond markets.

All the modeling tools, the historical context, can try that out of asset camp dot com before we continue, limit, pause and share some words from this week. sponsors. I've been using monarch money as my main tour.

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Listeners of this show will get an extended thirty day free trial when you go to monarch money dot. Come slash David, that's M O N A R C H M O N E Y dot comes last, David, for your extended thirty day free trial. So I used to ask a camp, and I wanted to know ten years ago, August twenty fourteen, what was a yellow maturity for bonds and what was the subsequent ten year return for the U.

S. aggregate. So this would be U. S. Investment grade bonds, corporate or expected current treasury bonds. In August twenty fourteen, the starting year to maturity was two point two percent. The ten year analyzed return was one point six percent.

And on asia camp, we we show bond return tables and stock return tables going back twenty years. But there's also a the fully tool that you can measure any time period you want as long as we have the index data going back that far. So that was U.

S, I agree, get pretty close within sixty basis pots. U S, hio. Bds, starting at the maturity August twenty fourteen, five point two percent ten year analysts return four point six five percent analysts, again within sixty basis points.

U. S. treasury. So all U. S. Treasury starting ultimatum ity, in August twenty fourteen, one point four percent.

Ten year analyst return was one point two percent. So that was super close. Here's one know that didn't do so well.

U. S. Treasury, long term, the starting of the maturity was two point nine percent.

The anio s. Return over the past decade was zero point seven percent. why? Well, the J P.

Morning paper mention that you need your least hold the asset for its duration. And the duration of U. S. Treasury long is about fifteen years, and so we haven't had a fifteen year time period spirit. So hopefully we'll get close to that.

The other thing that impacted IT is that to rise in interest rates from july twenty twenty two to october twenty twenty three when the fed was raising policy rate and longer term, right to unarm, that index return negative seventy percent. Analyst, so IT fell significantly for a longer term bond. In order to get that starting in the maturity, you need to hold IT longer.

But how much interest rates change can influence IT to some extent. We include an as a camp, a bond market expected return model where you can measure the impact and the expected return for one year after ten years based on changes and interest rates, changes and default. And if we think about that, U.

S. Treasure long, if this is right, rose two percent based on its starting the maturity today, four point three percent, the angle return over the next two years would be negative eleven and a half percent. And i've never had access to IT, even as an advisory to model.

How much could I lose with my bond friend? If interest rates go up, what's the expectation return for three years figures? How long we have to hold IT in order to earn that starting maturity now can model IT and you can model IT to with us.

The other thing that we can get is historical perspective, the starting yield to maturity right now for the broad U. S. Bond market is measured by the aggregate that the vanguard total bomb marketing tf would invest in its four point two percent.

That is our expectation for the return over the next six, the ten years. That seems like a good yield, especially compared to december twenty twenty. The ultimatum ity, then the U. S. Agreed index was one point one percent that would have been the expectation had used.

This initiated an investment in december twenty twenty, now were at four point two percent, the long term average going back to one thousand nine hundred and seventy six is six point two percent back in nineteen and eighty one. Had you invested in an index fun that track the U. S.

Aggregate, the starting the maturity was over sixteen percent. So rate can get that high. We have seen IT. There is no guarantee that rates will fall, especially given the level of the national debt, the national that keeps growing deficit still large at some point bomb market participants could get worried and the term premium could increase meaningfully, leading to higher interest rates.

The other interesting thing to consider, and we can also see this an acid camp, is what is the incremental yield or spread for investing in corporate ones, be them not investment grade or investment grade? This is important when we talk about, all right, the fear of cut interest free to half a percent. Will a recession come? If financial market anticipate a recession, they'll be worried about bond fault, and they will want additional yield above treasuries to invest in non investment great bonds or investment great corporate bonds.

The current spread or incremental yield above ve treasuries for non investment gate bonds, U. S is three percent, the long term averages four point nine percent. If there's a worry about recession, that spread should be above the long term average.

Five, six, eight percent is the same for global, not investing great bonds and and there's charge and act that you can see the spread, the current spread, but how IT goes over time, what the average is and how many standard deviations we are from the average global high iee bonds, the current spread is three point seven percent. The long term average is five and half percent. So again, the global market is not anticipating a recession based on how the pricing non investment grade bonds.

The first thing I want to talk about today, and it's something that I discussed couple years ago on a plus episode, it's how the duration or interest sensitivity of bonds changes based on interests. A boundary is a mathematical estimate of its Price sensitivity to changing interests. IT measures how much index Price or bonds Price or etf Price will change with a one percent change in intestate.

If we have A A bound tf with a duration of six years and interest strates to go up by one percent, then the Price of that bond, T, F, which fall about six percent. Now again, this is a rule of fun, but IT is it's pretty effective. That's how duration is used and that's how we use IT in our expected return model.

We look at the the duration. We look at the change and rates. Now we do is my small adjust for convection convexity being a way to estimate how a duration of a bond index E T A for individual bond will change as interest rates change because the donation interstate sensitivity will change and will give you example that here in the moment, we'll get in the way to a little bit.

Duration is calculated by taking the waited average of the bond T, F or individual bonds cash flow. It's interest payments, it's principle payments. So it's figure out what's the waited average amount of that cash flow.

And it's a present value calculation is looking at those future cash flows and it's putting them in to today's dollars. And so when we think about that, the higher the yield or interest ate use to take those future cash lows into the present, the lower the present value and effectively the lower the duration. What that means is when yields are higher, durations are lower and when ultimatums are low, duration is higher.

And as a camp gives you the historical perspective because we can see a graph of the duration over time, ano graph at the yield over time. And so let's just take the U. S.

Treasury ten to twenty year index by bloomberg in november nineteen ninety four, the year to maturity was eight percent for this index comprised of U. S. Treasury bonds with maturity between ten and twenty years, so the yellow maturity was eight percent.

The duration was seven point three, so the duration was as low as has been since going back to one thousand hundred and ninety two. Because the yields are so high, higher yields equals lower duration because as higher yields are are used to discount those interest payments in principle payments into today's dollar. If you go and look at what what was the duration when actually really low in july twenty twenty, the yellow maturity on the bloomer tended twenty judy bond index.

The year was zero point nine percent, so super low, and the duration was closed to fifteen. And so duration was shift over time based on where interest rates far. And so when IT rate a low, that the potential Price decline due to interest going up is much higher.

So somewhere like japan right now include a japanese bond index on asia camp. They have really low yield under one percent, which means the duration and interest rate sensitivity is very high. Now, this is bond in the weed stuff, but also some basic bond principles we need to understand intestate, sensitivity, duration, yelled, how to use those to estimate and expect return for bond funds and bond E.

T. S. Once I uncovered my in traditional financial media, stocks are way more sexy on money for the rest of us, though we cover both. We've done as many episodes on bonds as we have on stocks, and we've built tools to analyze both the stock market and the by market.

For acid delegator portfolio builders like us, we talked about the five levels of investing a few episodes ago as as the managers were focused on level four and five building up portfolio. And for that, we need tools. We've launched as the camp the bond market tools this week.

You can give them a try where integrates gonna go from here. We don't know trend potential is down, but IT does depend on what inflation does IT depends on the term premium. Market participants and federal market open committee members are not very good at predicting.

That's why it's important that either lack in yield using an individual bond or a bullet bond, F, A, C still looking and attractive yields. But if we're going to invest in a body T F uh, traditional ones such as B N D, then we need to understand what's the expected to return. And we need to know the current year, the maturity.

We need to know its intestate sensitivity, duration and in fact, or that in to make sure that our time horizon is faciendo long, that if interest rates go up, we can still earn that yield to maturity. So there's where the bond market is today. We will see how things evolved.

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