Rates are Falling: Should you consider Bonds over Cash?
INVESTMENT COMMITTEE COMMENTARY August 2024
The S&P 500 closed August near an all-time high and recovered from a sell-off early in the month. For the month, the S&P 500 rose 2.4%.
Market volatility increased at the beginning of August. Many markets experienced a broad “risk off” trade leading to declines in U.S. and Japanese equities. The ten-year Treasury yield fell to 3.78% on August 5th in response to some weaker than expected economic data and rate hikes by the Bank of Japan. At that time, we thought the sell-off was driven by a combination of profit taking, the covering of extended positions by select market participants, and a broad recognition of risks shifting from inflation towards slowing economic growth. After August 5th, three factors influenced the market rebound: solid economic and inflation data offsetting concerns from the August jobs report, the Federal Reserve (Fed) announcing “the time has come” to begin cutting interest rates, and decent corporate earnings.
In the last two years, the technology sector and stocks tied to artificial intelligence (AI) have led the U.S. stock market rally. Morningstar reports the most recent tech market peak came in mid-July. Since then, there has been a rotation away from large cap tech and AI stocks. As tech prices became more overvalued, investors began shifting to less expensive mid and small cap stocks and real estate investment trusts (REITs). Such market shifts come about quickly and cannot be timed. As noted above, the S&P 500 rose 2.4% in August even though six of the top seven contributors to the market rally since 2022 (Nvidia, Microsoft, Alphabet, Apple, Amazon and Broadcom) have been leading detractors relative to the overall S&P 500 since mid-July.
Bond prices rose as the yield on 10-year Treasuries fell from 4.09% to 3.92% in August. The Bloomberg U.S. Aggregate Bond Index posted a 1.4% gain for the month. Other bond sub-asset classes also rose in August. Year-to-date total returns for fixed income investments are positive, generally over 3%. Of note, U.S. high yield corporate bonds are up 6.3% through August.
In 2021 and 2022, the Fed raised short term rates from 0.25% to 5.25% to combat inflation. The Fed action caused the yield curve to “invert” so that short-term bond rates became higher than long-term rates. Treasury yields have been inverted since July 2022, the longest period on record. Now that the Fed has brought inflation under control, the Fed has shifted focus to reducing rates to a level which will support continued economic growth. As a result, we are seeing the yield curve beginning to normalize. As of August 31st, the yields on 2-year and 10-year Treasuries are effectively the same at 3.91%. Yields on Treasuries with maturities less than 2 years remain higher, but as the Fed lowers short term rates, the yield curve will return to its normal state with longer term bonds paying higher rates.
Rates are Falling: Should you consider Bonds over Cash?
The anticipated Fed interest rate cuts in September will change the interest rate environment. US Bank notes that investors hold more than $6 trillion in money market funds as some investors have moved to higher short-term interest rates since 2022. Going forward, there may be more profitable choices to consider for investor cash reserves parked in money market funds and certificates of deposit (CDs).
Money market funds and CDs serve an important role to meet immediate cash needs in savings and reserve accounts. The key attribute of these funds is liquidity and the ability to convert to cash quickly. The yield on these funds is tied to short-term market rates, currently about 5.1%. However, in a falling rate environment, these securities suffer from risk that their proceeds will not be reinvested at the same high rate, often referred to as reinvestment risk. Longer-term bonds benefit from the ability to lock in current rates, causing them to appreciate if rates fall further.
For cash held above reserve fund needs, some investors are shifting their cash toward longer-term bonds which generate higher returns in falling interest rate environments. The chart below illustrates the return impact on various fixed income sub-asset classes depending on whether interest rates rise or fall by 1%. For example, 2-year and 10-year Treasuries both have a yield of 3.91% on August 31st. If interest rates fall by 1%, the total return on 2 and 10-year Treasuries would increase to +5.8% and +12.1%, respectively. If interest rates rise by 1%, the total return on 2 and 10-year Treasuries would fall to +2.0% and –4.3%, respectively. Longer duration bonds are more interest rate sensitive.
We believe it is a good time to reassess cash and cash equivalent holdings. Interest rates already have come down (about 1% since late April on 10-year Treasuries) resulting in positive fixed income returns. In this environment, we favor holding limited or intermediate duration bonds over excess cash.
If you have any questions or wish to review your portfolio asset allocations, please consult your JMG Advisor.
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Market Segment (index representation) as follows: U.S. Large Cap (S&P Total Return); U.S. Mid-Cap (Russell Midcap Index Total Return); Foreign Developed (FTSE Developed Ex U.S. NR USD); Emerging Markets (FTSE Emerging NR USD); U.S. REITs (FTSE NAREIT Equity Total Return Index); Foreign REITs (FTSE EPRA/NAREIT Developed Real Estate Ex U.S. TR); U.S Bonds (Bloomberg US Aggregate Bond Index); U.S. TIPs (Bloomberg US Treasury Inflation-Linked Bond Index); Foreign Bond (USD Hedged) (Bloomberg Global Aggregate Ex US TR Hedged); Municipal Bonds (Bloomberg US Municipal Bond Index); High Yield Bonds (Bloomberg US Corporate High Yield Index).