Incoming Fed rate cut? Here is how to position for it.

• We see the possibility of a Fed rate cut, but it is unlikely the start of a cutting cycle. 
• Despite the potential rate cuts, we believe Fed Funds Rate is likely to remain above the pre-pandemic levels. 
• Short-duration bonds continue to be our top preference. 

Since late last year, highlighted in our iFAST 2024 Global Fixed Income Outlook, we outlined our case for no Fed rate cuts in 2024. This was a contrarian stand back then as markets have priced in multiple cuts this year, contrary to our projections.

For nearly nine months, we have strongly held on to this view and has been proven right repeatedly as markets pushed back the timeline for rate cuts. That said, we think the time has come for us to pivot from this view as we now see a rising possibility of Fed rate cuts in September’s FOMC meeting.

High possibility of Fed rate cuts if economic data continues to moderate

US inflation data has declined steadily from its peak after the Fed greatly raised policy rates. Particularly, the Fed’s preferred reference for inflation data – the US Core Personal Consumer Expenditure (“Core PCE”) Price Index has eased to 2.63% year-on-year (“YoY”) in June (Chart 1), inching closer to the targeted 2.0%. Another inflationary measure closely monitored by the Fed, the US Supercore PCE which further strips out shelter and rent from core inflation fell to 3.43% YoY, from the peak at 5.25% in December 2021.  

Meanwhile, the US labor market has also shown signs of loosening with a rise in unemployment rate and drop in job creation, as suggested by recent non-farm payrolls readings (Chart 2). Considering the Fed’s data-dependent stance - where the trend of key economic data influences policymaking decision – we now see high possibility of rate cuts if key inflation and labor market data continues to trend lower.

Looking back at FOMC meeting minutes and commentary by Fed Chairman Powell, we also see sufficient hints for a Fed rate cut. In early August, Powell commented that “a reduction in our policy rate could be on the table as soon as the next meeting in September”.  During the Jackson Hole symposium, he further stated that “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”

Chart 1: Various US core inflation measures

Chart 2: Various US labour indicators

No need for the Fed to rush rate cuts. Unlikely the start of a rate cut cycle

While Fed rate cuts may materialise as soon as September, we do not think it will be the start of a typical rate cut cycle. We believe the descent in inflation may remain bumpy and take longer than expected to be under control.

Higher Fed fund rates rate have worked well to subdue some aspects of inflation but not all of it. Shelter inflation – at around 38% of the CPI basket - remains elevated and contributes to a slower decline in US inflation. At present, shelter inflation remains supported by a resilient US housing market, with housing supply still lower than the pre-pandemic period. Despite a recent moderation, US housing prices across the nation and core US cities stands elevated, which would likely provide a support for rental prices to stay high (Chart 3).  

To complicate matter, shelter inflation often works with a lag to the broad housing indicators like rent asking price and home prices. CPI’s methodology of evaluating shelter prices typically see a lag of 6 to 10 months, primarily due to the extensive effort for manual data collection and a need to account for lease dynamics. As a result, CPI lags behind indicators such as Zillow Observed Rent Index, which appears more updated with the current conditions. Recent data showed that these broad housing indicators have stalled, which suggests that the deceleration for shelter inflation may slow in the coming quarters and may impact the descent in US inflation.

Beyond the sticky components, short-term and long-term inflation risks remains present, compounding to our worries of a slower decline in inflation. Tensions in the Middle Eastern region continue to be a near-term upside risk to inflation, particularly through its potential impact on oil prices. Recently, tensions between Israel and Hezbollah in Lebanon escalated yet again, inducing significant volatility on oil prices. Just this week, Libyan oilfields are facing shutdowns as the government factions argue over the decision of its central bank governor.

Beyond the near-term, structural factors support the case for higher long-term inflation. Green transition and deglobalisation (i.e. the ongoing trade tensions between the East and West) have accelerated in recent years and are expected to exert upwards pressure on inflation in the long run. The amalgamation of these short and long-term factors fuels our concern about on the decline in inflation as markets overly optimistically look past such risks.

Together, we think the above factors can contribute to a bumpy descent in US inflation, which may take longer than expected to be under control. History shows that disinflation rarely follows a linear pattern. It comes in waves with several peaks and troughs, as evidenced by the inflationary periods in the 1940s and 1970s (Chart 4), during which there were several unexpected inflationary surges. Therefore, we see no need for the Fed to rush rate cuts as slashing rates aggressively runs the risk of a resurgence in inflation akin to the 1970s where Arthur Burns, the Fed Chair, failed to keep monetary policy tight for long enough to permanently quell inflation.

Chart 3: US CPI, US Shelter CPI and US housing/rental indicators (%)

Chart 4: Headline CPI inflation across history (%)

Short-duration bonds remain our top pick

Attractive income from short-duration bonds. Elevated policy rates across the world continue to support yields on short-duration bonds which remain high relative to history. Without a Fed rate cut cycle, we think short-end US treasury yields can remain higher for longer. Major central banks - like the ECB - which have cut rates continue to be data-dependent and cautious. Even as these central banks begin their rate cut cycle, we expect the speed and frequency of future cuts to be gradual as well. Therefore, global short-term yields could remain elevated in 2H24.

Yield of global bonds between 1 to 3 years maturity currently stands at about 3.3% (Chart 5) - significantly higher than the 1.0% yields on average since the GFC until we saw the first rate hike in February 2022. While yields on the longer duration bonds have also increased – now ~3.6%, from previously an average of ~2.2% – short-duration bonds appear to offer better value at a similar yield, but with significantly lowered duration risk exposure.

With markets pricing in aggressive Fed rate cuts, we see a high likelihood of for consensus to backtrack on the rate cut expectations, or flip-flop between narratives (of aggressive and minimal cuts). These shifts in market sentiment and expectation can result in extensive volatility across treasury yields. As such, short-duration bonds can offer investors protection against such swings given lesser sensitivity to changes in yields.

Cautious on longer duration bonds after the sharp drop in yields. We remain cautious on longer duration bonds especially after the sharp drop in long-term yields, reflecting markets’ aggressive Fed rate cut expectations (Chart 6). Two reasons anchor our view.

First, we think long-term yields may see limited room to decline if Fed rate cuts materialise, as cuts have been aggressively priced in. Over the past three months, the 10-year US treasury yield has fallen by 73 basis points (“bps”) (as of 28 August 2024). This is much larger than the typical decline in yields, which averages ~54 bps, seen over the past four occasion when the Fed first cut rates (2019, 2007, 2003, 2001). We think this large drop in yields is also a reflection of markets’ lofty expectations of four rate cuts by end-2024. Any substantial drop in yields subsequently would likely require more rate cuts to be priced in by year-end or early-next year, which is unrealistic in our view.

Second, given the aggressiveness of rate cut expectations, we see a larger outcome for things to go wrong – this includes inflation surprises, less dovish Fed, and post-election fiscal stimulus. This would mean a larger probability for markets to temper its aggressive Fed cut bets which would likely push long-term yields higher, leading to larger mark-to-market losses. We have seen this situation earlier this year in 2Q where markets’ expectation of Fed cuts was repeatedly pushed back.

Chart 5: Yields of global bonds grouped by maturity (%)

Chart 6: Fed Funds Rate Expectations (%)

Our recommendations

Across the USD bond space, we currently prefer USTs over corporate issuances, considering the minimal spreads that investment-grade issuances are offering over the risk-free rates. As such, investors are highly recommended to consider the shorter tenor USTs, predominantly within 2 years of maturity given the still-elevated short-end rates.

Within the SGD bond space, we still see attractively priced short-duration offerings for investors, by issuers we identified to have a positive, or at least stable, outlook in the near term. These recommendations follow our previous coverage of the SGD bond market - Here are the gems across the SGD bond space amidst falling yields.

Table 1: Investment-grade SGD options

Table 2: Higher yielding options within SGD bond space

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) hold a position in USTs of varying maturities, STRTR 3.750% 29Oct2025 Corp (SGD), STRTR 4.100% 04May2026 Corp (SGD), OUECT 3.950% 02Jun2026 Corp (SGD), GUOLSP 3.290% 26Oct2026 Corp (SGD), and OLAMSP 4.000% 24Feb2026 Corp (SGD) while the analyst who produced this report hold a NIL position in the abovementioned securities.