In his Jackson Hole speech in August, Federal Reserve Chair Jerome Powell gave his clearest direction yet on where he expected the central bank to take interest rates. Powell suggested that “the time has come for policy to adjust,” although he also remained steadfast that “the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
Now we know exactly how the Fed feels about the balance of risks in the economy. The Fed’s announcement on September 18 to cut interest rates by a 0.5 percentage point demonstrated only a passing concern for future inflation. Stock market participants everywhere can now breathe a sigh of relief as the market is likely to perform well as rates continue to fall.
Savers and fixed-income investors might be the ones on their back foot now. It is officially time to wake up to the fact that cuts are only just beginning. Yields are falling, and this will hurt cash savings and short-term investments. While we are unlikely to return to the days of zero interest rate policy, cash and cash equivalents won’t be the slam dunk they have been during the past two years. In this new environment, interest rates will fall, and the yields on cash will degrade.
Declining yields
The next Federal Reserve meeting in November will show how urgently Powell and the Federal Reserve governors believe our economy needs further relief. Recently available data continues to show waning job growth, rising unemployment and moderating inflation. Powell’s comments about supporting the job market show that he is attentive to these trends.
As of this writing, the odds point strongly to a 0.25 percentage point cut in November, according to the CME FedWatch Tool. Looking further out, interest rates could be 1.5 to 2.0 percentage points lower by the end of 2025. This means investors need to be prepared for how they will deploy current and future cash over the next year to make the most of this rotation.
The easy choice of just steadfastly piling up cash or purchasing three-month Treasuries for a risk-free 5% is all but over. It behooves investors, especially retirees, to think about how much risk they are willing to take on to maintain the returns they need over the medium term. Anyone who was left panicking over the early August stock market rout should act soon to lock in still-high, long-term, fixed income investments before the stock market becomes the only game in town again.
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Repositioning cash
Lower rates on cash and equivalents will push investors to seek more yield elsewhere, and we’re already seeing individual and institutional investors repositioning. The rotation out of cash, CDs and other “safe” options won’t happen overnight, but savvy investors should be plotting a course to take advantage of the cutting cycle. Unlike the market environment pre-2020, bonds have the potential to meaningfully add to a portfolio’s total return. The death of the 60/40 portfolio was greatly exaggerated, in my opinion.
Some passive management purists might suggest that making tactical adjustments to your portfolio is a mistake, the dreaded heresy of “timing the market.” In fact, I believe planned adjustments like this are more likely to insulate you from the emotional need to make timing-based decisions in the future. Securing your cash now into yield- or growth-producing assets will leave you with a more robust portfolio regardless of volatility spikes in the future. There is a difference between reacting to market turmoil and making measured investments in light of one of the most telegraphed policy moves in years.
Evaluating your own risk tolerance is key before making any changes. For risk-averse investors, transitioning from a money market or short-term Treasury fund into a longer-term, fixed income investment will offer higher rates for longer in a secure investment vehicle. For investors with a higher risk tolerance and a long-term investment horizon, allocating contributions toward stocks offers the highest expected return in the long term. Certain sectors, such as utilities, real estate and consumer discretionary, tend to perform especially well during rate-cutting cycles.
Considerations for retirement planning
A robust, all-weather retirement income plan requires a blend of three things: flexibility, growth and guarantees. Investors have a lot of flexibility at the moment, with over $6 trillion sitting in money markets, per the May report from PIMCO. While many investors were assessing how and when the next market shock might come, earning a comfortable rate on cash was a no-brainer. Today, on the precipice of an interest rate-cutting cycle, that flexibility will come at a greater cost soon.
Retirees should think carefully about how much they need in an emergency fund and how accessible they need their “safe” money to be. The tug-of-war between principal protection and growth is going to be more competitive as incremental yield will require added risk. As rates begin to settle at a lower, more permanent level, retirees should remain diligent about balancing the income and growth elements of their portfolios. In time, lower yields will mean more money will need to be allocated toward income production.
One of the key elements for retirees will be thinking a step beyond their asset allocation. Asset location is of growing importance as rates fall and future tax policy remains unknown until after the election. Asset location is a strategy of placing certain investments in tax-advantaged accounts to benefit from the preferential tax treatment of those accounts. As rates fall and investors need to search in earnest for yield, conservative investors will benefit most from maximizing after-tax returns.
This isn’t the first time, or the last time, the economy and market environment create reallocation opportunities. However, this might be one of the most telegraphed. Unlike the past interest hiking cycle in 2022, which was not only lightning fast but also a rise from an unprecedented low level, we have a strong sense of how the markets and economy will react to the Federal Reserve’s moves. Don’t let this moment pass you by to review your own financial position.
