Making Sense of the Fed's First Rate Cut Since 2008
- August 1, 2019
Our fixed-income portfolio managers weigh in on the FOMC’s decision to cut short-term interest rates and how it impacts the bond market and investors.
The Federal Reserve cut short-term interest rates on Wednesday for the first time since 2008, citing weakening global developments and muted inflation pressure. In an 8-2 vote, the FOMC lowered the target range for the federal funds rate to 2% to 2.25%. The dissenting votes were cast by Esther George and Eric Rosengren, who favored maintaining the target range at 2.25% to 2.5%. While the Fed acknowledged that the job market remains strong and economic growth is rising at a moderate clip, FOMC members noted that growth of fixed investment among businesses has been “soft.”
We believe the Fed’s interest-rate cut and recent dovish remarks are not necessarily an indication of a weak economic outlook that would justify a continuous easing program. Rather, they signal an “insurance cut” by a central bank searching for a new equilibrium, or neutral rate, in the face of weakening global conditions and trade uncertainties. Equilibrium is the prevailing real interest rate when the economy is at full employment and inflation is hitting the Fed’s target. We see the muni market keeping pace with taxable bonds, despite historically expensive valuations fueled by changes in market technicals.
We believe that a “lower for longer” interest rate will persist longer than expected. Additionally, we don’t expect a significant increase (or decrease) in rates across the entirety of the yield curve for an extended period of time. While 0.25% to 0.50% of volatility is possible, the long-run trend points toward persistent lower yields versus the historical norm. Another factor contributing to the low-rate environment is the accommodative stance of global central banks. This stance has held yields down around the world, with many 10-year sovereign bonds earning less than the U.S. Treasury. Yields in Germany, France and Japan are all negative in 10-year maturities. Greece, the poster child of financial instability in the European Union only a few years ago, now has 10-year bond yields equivalent to the United States! With growth and inflation negligible in many parts of the developed world, there are few viable investment options that can compete with U.S. Treasuries on a risk/reward basis.
In our view, recession risk remains lower than current bond-market pricing implies. Further, we see domestic growth remaining near its potential, while trade-war effects look more limited and the labor market seems to remain healthy. Right now, the yield on the 10-year Treasury is hovering around 2%. For fixed-income investors, we think corporate bonds still offer a reliable source of yield above Treasuries. For our taxable bond strategies, we are positioning portfolios to be dependable components of an overall asset allocation. As such, we remain focused on producing income—not overreaching for yield—and taking advantage of market opportunities. Looking ahead, we anticipate corporate bond spreads to remain flat for the remainder of the year. Generally, we’re underweighting commodities and cyclicals and overweighting consumer and defensive sectors in credit.
Disclosures
Tax-Exempt Municipal Bonds are issued by state and local governments as well as other governmental entities to fund projects such as building highways, hospitals, schools, and sewer systems. Interest on these bonds is generally exempt from federal taxation and may also be free of state and local taxes for investors residing in the state and/or locality where the bonds were issued. However, bonds may be subject to federal alternative minimum tax (AMT), and profits and losses on bonds may be subject to capital gains tax treatment. Municipal securities may lose their tax-exempt status if certain legal requirements are not met, or if tax laws change. The financial condition of the issuer may change over time and it is important to monitor the changes because they may affect the ability of the issuer to meet its financial obligations. The MSRB's EMMA website (www.emma.msrb.org) allows investors to sign up to receive alerts about the availability of important information that may affect their municipal bonds. The MSRB makes official statements and continuing disclosures submitted to it by issuers and others available to the public for free through its EMMA website. EMMA also provides municipal securities trade price information through its Real-time Transaction Reporting System ("RTRS") and free public access to certain municipal credit ratings. See more at: http://www.finra.org/investors/alerts/municipal-bonds_important-considerations-individual-investors#sthash.snkM0mxf.dpuf
High-yield bonds, those rated below investment grade, are not suitable for all investors. The risk of default may increase due to changes in the issuer's credit quality. Price changes will occur as a result of changes in interest rates and available market liquidity of a bond. When appropriate, these bonds should only comprise a modest portion of a portfolio.Liquidity risk refers to the risk that investors won’t find an active market for a bond, potentially preventing them from buying or selling when they want and obtaining a certain price for the bond. Many investors buy bonds to hold them rather than to trade them, so the market for a particular bond, or a small position in a bond, may not be especially liquid and quoted prices for the same bond may differ. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.
© 2019 Oppenheimer Asset Management Inc. This commentary is intended for informational purposes only. The information and statistical data contained herein have been obtained from sources we believe to be reliable. Oppenheimer Investment Advisers (OIA) is a division of Oppenheimer Asset Management Inc. The opinions expressed are those of Oppenheimer Asset Management Inc. (“OAM”) and its affiliates and are subject to change without notice. No part of this presentation may be reproduced in any manner without the written permission of OAM or any of its affiliates. Any securities discussed should not be construed as a recommendation to buy or sell and there is no guarantee that these securities will be held for a client’s account nor should it be assumed that they were or will be profitable. Past performance does not guarantee future comparable results
Special Risks of Fixed Income Securities: There is a risk that the price of these securities will go down as interest rates rise. Another risk of fixed income securities is credit risk, which is the risk that an issuer of a bond will not be able to make principal and interest payments on time. Neither OAM nor its affiliates offer tax advice. OAM is a wholly owned subsidiary of Oppenheimer Holdings Inc. which also wholly owns Oppenheimer & Co. Inc. (“Oppenheimer”), a registered broker/dealer and investment adviser. Securities are offered through Oppenheimer and will not be insured by the FDIC or other similar deposit insurance, will not be deposits or other obligations of Oppenheimer or guaranteed by any bank or other financial institution, will not be endorsed or guaranteed by Oppenheimer and will be subject to investment risks, including the possible loss of principle invested. Liquidity risk is the risk that you might not be able to buy or sell investments quickly for a price that is close to the true underlying value of the asset. When a bond is said to be liquid, there's generally an active market of investors buying and selling that type of bond. 2665013.1