In 2022, the US Federal Reserve (“Fed”) began an aggressive cycle of interest rate hikes, aiming to curb inflation, which soared to multi-decade highs. Over the past two years, the Fed increased the Federal Funds rate (their policy rate) at a historic pace in response to these persistent inflationary pressures. That same inflationary rate has now begun to cool and the Fed has recalibrated their policy by lowering the Fed Funds rate (starting with a cut of 0.50% in September 2024).
At the current level of interest rates, investors have been able to generate a level of income that they haven’t been able to do for over a decade. Albeit the path to get there was painful, as:
· Equity markets fell in 2022 based on concerns of a potential recession from the aggressiveness of the Federal Reserve
· Bond prices declined precipitously in 2022 as well because of the inverse relationship they have with interest rates (as rates rise, existing bond prices fall)
For savers, however, some of these initiatives were beneficial. The aggressive actions of the Federal Reserve led to CDs and money market accounts with four percent yields or higher. For spenders, the cost to borrow in rising rate environments can be painful and stretch affordability as mortgage, auto loan, and credit card rates also increased rapidly. The chart below shows the Federal Funds rate from 2021 and includes the future expectations out to December 2025.1,2
The Federal Funds rate is important because it dictates the level and direction of shorter-term interest rates that many interest-bearing products follow. This means if the Fed Funds rate goes up, so do CD rates and money market accounts. It also means if the Fed Funds rate goes down, so do the rates you can earn on CDs and money market accounts. With the expectation the Federal Reserve will continue to lower interest rates, it means savers will be able to earn less in the future on products like CDs and money market funds.
In contrast, longer-term interest rates are dictated by investor sentiment about economic conditions and not controlled by the Fed. Additionally, investors demand additional yield to purchase something that has less certainty, which is why longer-term interest rates are historically higher than shorter-term interest rates.
The table below shows the additional average yield a treasury bond has over the Fed Funds rate over the last 30 years. For example, if the Fed Funds rate were 3%, on average, a 2-year US Treasury would have a yield of 3.11% (3% + 0.11%) while a 10-year Treasury would have a yield of 4.27% (3% + 1.27%). Note, these are merely averages based on the last 30 years and are not indicative of rates at all times.2
The most likely consequence of the Federal Reserve lowering interest rates is that income generated from CDs and money market accounts will begin to fall and investors will have to choose other areas with higher risk to generate a similar level of income. At Gradient Investments, we have a number of ways for investors to earn income. The most conservative portfolio is the Stable Value portfolio, but income generation in this portfolio will likely follow the path of the Fed Fund’s rate closely. However, portfolios such as the Laddered Income Series or the Fixed Income Total Return could increase yield (and subsequently income) but also increase portfolio risk. Lastly, there are the Absolute Yield and Designed Income portfolios, which have higher risks but can be used for premium yield and as part of the overall income strategy. In our opinion, it is best to balance the level of yield and income generation with a suitable level of risk that is based on a well-defined investment plan.
2. https://fred.stlouisfed.org/
Posted here by Tyler Ellegard, CFA® on Oct 10, 2024