Global Central Banks Shift Focus: Rate Cuts Signal Changes for Investors

According to Shannon Kirwin, Associate Director of Fixed Income Strategies at Morningstar, central banks globally are embracing a wave of rate cuts as the battle against inflation, fought between 2021 and 2023, seems to be nearing its end.

Recent Rate Cuts by Major Central Banks

The European Central Bank enacted its fourth consecutive rate cut on December 12, reducing its key cash rate to 3.15%. Meanwhile, the US Federal Reserve made its move in September and November, leading to a decrease in the federal-funds effective rate to 4.64% by the end of November. The economics team at Morningstar anticipates that this rate will dip to between 4.25% and 4.50% by the end of 2024, fall to 3.00% to 3.25% by the conclusion of 2025, and reach 2.00% to 2.25% by the close of 2026.

A Return to Normalcy?

These adjustments indicate a potential return to stability within the fixed income markets after a period characterized by heightened short-term yields. However, they also imply a significant decrease in income generated from bank deposits.

Investor Implications: Cash Hoards and Long-Term Strategies

This could serve as a reality check for investors, many of whom may still be holding onto large cash reserves. Data from the Investment Company Institute shows that assets within money market funds surged to approximately USD 6.5 trillion by October 2024.

A closer inspection of net monthly flows in money market funds reveals that many investors have yet to dismantle their substantial cash hoards accumulated during the height of the COVID pandemic.

The Case for Longer-Dated Bonds

History suggests that maintaining funds in cash rather than investing in longer-dated bonds rarely benefits those with a long-term investment approach. With current yields on developed-market government bonds being more appealing, the case for extending across the yield curve becomes particularly persuasive.

If anticipated rate cuts materialize, investors could gain by reallocating assets into longer-term fixed-income bonds to secure higher levels of income. For instance, the yield on a 10-year US Treasury bond was 4.2% at the end of November.

Assuming a 1% term spread between shorter and longer-term bond yields to account for risks, this suggests an expected average federal-funds rate of 3.2% over the next decade. In contrast, Morningstar predicts an average federal-funds rate of 2.3% in that time frame, making longer-term government bonds particularly attractive compared to cash deposits.

Intermediate US Treasuries: A Balanced Opportunity

Specifically, the intermediate segment of the US Treasury yield curve (bonds with life spans between five to seven years) presents a favorable risk/reward ratio. This range offers the potential for price appreciation without the heightened drawdown risk associated with 30-year bonds if rates unexpectedly rise.

Cautious Insights on Corporate Debt

However, not all facets of the fixed income market are signaling “buy.” Global corporate debt spreads, which reflect the risk premium for corporate issuers relative to government bonds, have reached their narrowest levels since 2005. This trend is driven by heightened market expectations of robust economic growth and accommodating central bank policies.

Parts of the market with higher risk are showing even greater prices; for example, US high-yield corporate bonds have hit their tightest levels in history. While it is uncertain if prices will drop in the near future, prudence is advisable when investments come at such a high cost.

Discovering Value in Emerging Markets

Where can investors find potential bargains in the global bond market? Certain local-currency emerging-market sovereign bonds appear promising, often offering nominal yields that surpass current inflation levels and central bank targets.

For instance, Brazil’s five-year bond yield at 13.3% stands out against an inflation rate of 4.4%, while Mexico is issuing five-year debt yielding 10.4% against a CPI of 4.6%. In contrast, Japan experiences negative real yields with a potential for more interest rate increases in 2025 if conditions persist.

However, investing in local sovereign bonds typically involves exposure to local currencies, which can be quite volatile, especially in emerging markets.

Conclusion: A Strategic Approach to Portfolio Management

Investors keen to transition their cash into higher-yielding assets still have opportunities, particularly in high-quality, intermediate-term government bonds. While there are pockets of value amid riskier emerging-market debt, such allocations should form only a fraction of a well-diversified portfolio due to their inherent volatility.

High-yield corporate debt can also play a valuable role in a balanced portfolio, even as it appears expensive at this moment. With prevailing data suggesting a potential correction in lower-quality credit, most investors may find it prudent to establish a long-term asset allocation strategy rather than trying to time the market optimally.