- The recent banking crisis shifted market expectations for the peak Fed funds rate down by 0.75% to around 5.00% since the beginning of March 2023.
- Long-term yields have started to drop as markets price in a higher likelihood of a recession, which should benefit the fixed-income side of client portfolios.
- It is important to pay off any variable-rate loans and take advantage of high-yielding money markets or savings accounts given where rates are today.
Amidst Market Turmoil, AllGen Sees Investment Opportunities in the Bond Market
The first few weeks of March have managed to turn financial markets on their heads – the number of changes we have seen as it digests the new information on the recent banking failures has kept investors on the edge of their seats. Not happy with the market today? Well, just wait till tomorrow, it might change. We cannot say with certainty how long these bank worries will last, but we can say that we are positioned defensively in client portfolios and that the swift action taken by The Federal Reserve, FDIC, Treasury, and other banks to support the financial system has stamped out some of the fires. Amid the banking turmoil, we are seeing opportunities within bonds. Long-term yields are dropping with the Fed funds rate possibly peaking (the interest rate the Federal Reserve controls).
Expectations for the Fed Funds Rate
It’s likely that the Fed funds rate will peak around 5%, and we expect it to decline before year-end. In other words, the Fed may hike 0 to 1 more times and then end up cutting rates before the end of 2023. Since the onset of the banking failures, the markets are pricing in for the Fed funds rate to fall faster and sooner. When rates rise, bond prices typically fall to keep lower-yielding bonds competitive with newly issued, higher-yielding bonds. This relationship worked against bond investors in 2022. Yet, it may finally help investors in 2023. For more information on how bonds work, read the Fundamentals of Investing: Bonds.
At the beginning of March – before the banking issues – markets priced in at least two more rate hikes, illustrated by the red dotted line in the chart below. Now, expectations have shifted down, with the gray dotted line representing what the markets are pricing at as of 3/23/2023. This shift in expectations for the Fed funds rate coincides with the market pricing in a higher probability of a recession, but more on that later.
The Fed funds rate has likely peaked.
The Federal Reserve focuses on targeting low inflation and full employment in the economy. To better understand this, we can use a temperature analogy: when the economy is running hot (as measured by inflation and employment), the Fed will try to cool it down through rate hikes. When the economy is running cold, then the Fed cuts rates to support inflation and full employment. Now, there’s always the risk to our outlook that inflation runs hotter for longer, causing the Fed to push rates higher. In that scenario, bond yields could rise further. However, we see this as a low probability. It’s more likely that the economy goes into a recession or is already in a recession, which could cause the Fed to cut rates.
The chart below shows the probability of the U.S. going into a recession according to a model produced by the Federal Reserve Bank of New York. In 2024, the chance of a recession is over 50% – that is higher than the probability was in the prior 3 recessions (recessions are shaded grey). If the Fed sees a looming recession or slowdown in the economy, then it is unlikely to hike rates.
The chance of a recession by 2024 is elevated.
Bond Market Performance in a Falling Rate Environment
What does this mean for bond market performance? Most likely, it indicates better performance for longer-term bonds. As such, we have added duration to the fixed-income side of our portfolios. Duration is a commonly used measure of how much a bond’s price will move in response to a change in interest rates – a higher duration means that a bond’s price will rise more when interest rates fall and vice versa. We typically shift from shorter-term bonds to longer-term bonds before the Fed cuts rates in an attempt to capture as much of that price appreciation as possible for our clients. In the chart below, long-term bonds, like 10- or 30-year Treasuries, see better performance relative to shorter-term bonds, like 2- or 5-year Treasuries, when rates fall.
Long-term bonds outperform short-term bonds when yields fall.
Financial Planning Tips for a High Fed Funds Rate
The Fed funds rate rose from 0.50% to 5.0% in the last year. Given the rise, most money market yields are now exceeding most savings account yields. Typically, internet banks or money market funds at brokerage firms pay a higher yield than your large brick-and-mortar banks. If you aren’t getting a yield of at least 4% on your cash, then it may benefit you to seek out a new solution.
We also suggest paying off any variable-rate loans. During the low-interest rate environment of 2020 and 2021, many of us took out variable-rate loans with good introductory rates, such as home equity lines of credit (HELOC). Yet, those low introductory rates aren’t forever. Rates will eventually reset to the prevailing rate (typically prime rate + a spread to compensate the lender). With the Fed funds rate standing at 5.0% as of 3/27/2023, it’s likely that the new rate will be higher and the cost to service that loan will increase. Average HELOC interest rates at the time of this article are around 7.78% on a $100k loan – that is $8,000 a year in interest!
Below is an example of a home equity line that was taken out in March 2021. The initial loan amount was $100,000 with an interest rate of 4.0%, which translated to a monthly payment of $333.33. To keep it simple, we assumed the rate resets in March 2023 to 8.0%. That doubles the initial rate to 8% from 4% and the monthly payment to $666.67 from $333.33 – that’s an additional $333.33 per month and $4,000 annually in interest.
Rising interest rates increase the cost of HELOCs.
It’s important to not be caught off guard when the rate resets and to pay down as much of the principal as you can (if not all the principal balance). The higher Fed funds rate could also affect other consumer loans, like credit cards, as they are more likely to have variable rates. If you have been with AllGen long enough, you know we always advocate for paying off all debt as part of our path to financial freedom.
What You Can Do Now
We always tell our clients, “You can’t control the markets, but you can control your personal finances and have a plan.” We are watching the markets and proactively adjusting client portfolios for the decline in rates. Yet, it’s important that you remain vigilant with your finances to make sure you are setting yourself up for success. If you do not have a financial plan yet, please reach out to your financial advisor so that we can help you put one in place.
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