Rethinking Cash in the Fed’s New Rate Regime

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Market regimes and the transitions between them can be difficult to observe, but sometimes such turning points become apparent. As an example, the Fed meeting of November 2021 brought a recognized pivot by the central bank to a hawkish policy stance wrought by persistent and elevated inflation. And for the subsequent 25 months, this Fed regime was defined by the fastest pace of fed funds rate hikes in history, and a persistent message that the fight against inflation was the Fed’s top priority. We can confirm the hawkish Fed regime ended on December 13, 2023, when projections from Fed officials signaled no rate hikes through 2026 and thereafter.

Throughout 2022 and most of 2023, the pace of increases in the fed funds rate and the resulting impact to the yield curve prompted a shift toward cash and other short-term investments like certificates of deposit (CDs), U.S. Treasury bills, and money market funds; these vehicles seemed like a safe alternative to high-quality fixed-income allocations. The two-year Treasury yield reached its highest level of 2023 (5.22%) on October 18, 2023; on that date, the year-to-date return on a basket of one- to three-month T-bills was a respectable 3.98%. (Unless otherwise indicated, all yield and return data presented herein are from Bloomberg.) As of that same date, the year-to-date return on one- to three-year investment-grade corporate bonds (as represented by the ICE BofA 1-3 Year Corporate Index) was lagging at 2.05%.

But with benign inflation prints and the Fed’s dovish pivot, the markets witnessed the potential of performance from duration positioning and credit-risk compensation. In the last 2½ months of 2023, one- to three-year corporates, buoyed by the Fed and the prospect of the inflation fight coming to a close, outperformed one- to three-month T-bills by over 2% and delivered a total return of 5.28%.

This outperformance represents a return to normal. As Figure 1 shows, short-term corporate bonds consistently produce higher returns than three-month T-bills following the last rate increase of a Fed rate-hike cycle. Beyond this immediate period after a hiking cycle, short investment-grade (IG) corporates provide a consistent and reliable excess return to Treasuries; over the past 20 years, short IG corporates have outperformed T-bills (as represented by the ICE BofA U.S. Treasury Bill Index) in 95% of rolling five-year periods (through January 31, 2024).

Figure 1. Short Corporates Have Outperformed Three-Month Treasury Bills After the Final Hike of Previous Fed Tightening Cycles

Source: Bloomberg. Short-term corporate bonds represented by the ICE BofA 1-3 Year Corporate Index. Three-month T-bills represented by the ICE BofA U.S. Treasury Bill Index. Data in chart summarizes returns for periods following the last fed funds rate hike in the previous seven tightening cycles by the U.S. Federal Reserve (1984, 1987, 1989, 1995, 2001, 2007, and 2019).
Past performance is not a guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

If we are transitioning to a new Fed policy regime, what might it look like? If the last rate hike has indeed taken place, the outlook for high-quality credit-risk premiums is favorable, as shown. At its January 31, 2024, meeting, the Federal Open Market Committee signaled that the fed funds policy rate had likely reached its peak; since then, the markets have priced in an expectation of approximately five rate cuts in 2024. The total number of rate cuts in 2024 is uncertain—and somewhat unimportant—compared to the Fed actually delivering a cut and beginning a new easing regime.

Figure 2 shows the average movement in Treasury yield for various maturities in the one year (six months before and six months after) surrounding the date of the first rate cut of the last four easing cycles. We have a few observations:

While the 10-year Treasury yield does decline, it declines the least in yield, on average, compared to three-month T-bills and the two-year Treasury. It is also our view that yield declines in previous easing cycles were largely driven by expectations of deep recessions correlated with financial crises and pandemics; the 10-year yield should not exhibit significant declines in this cycle due to the resilience and strength of the U.S. economy.
The two-year Treasury yield declines, on average, more than the 10-year Treasury yield, i.e., the yield curve steepens. This may provide a tailwind for short-duration assets, leading to compelling risk-adjusted returns in the short-duration space.
The decline in yield on the two-year Treasury note and three-month T-bill are similar in magnitude over the year. But, for the two-year Treasury, this decline in yield is a positive impact and potential benefit to total return, given the interest-rate exposure. For a three-month T-bill, the decline is a detriment to total return, given the cost of reinvestment at lower yields.

Figure 2. Tracking the Path of Yields Before, and After, Initial Fed Rate Cuts

Source: Bloomberg. Chart depicts average path of yields six months before, and six months after, the first cut in the fed funds rate in 1995, 2001, 2007, and 2019.
Past performance is not a guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Figure 3 shows that short-term corporates outperformed three-month T-bills by an average of 2.43% in the 12 months following the first rate cut, over the last seven easing cycles. Duration, interest-rate exposure, and credit risk have been highly volatile in past periods of Fed hawkishness. But in this pause before a potential new regime of Fed dovishness, duration and credit risk will be a tailwind to strong risk-adjusted returns for short-duration, fixed-income opportunities. In a dovish new Fed policy regime, cash is no longer king.

Figure 3. Short Corporates Historically Have Outperformed T-bills in the 12 Months Following Initial Fed Rate Cuts

Source: Bloomberg. Short-term corporate bonds represented by the ICE BofA 1-3 Year Corporate Index. Three-month T-bills represented by the ICE BofA U.S. Treasury Bill Index.
Past performance is not a guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

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Kewjin Yuoh

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Kewjin Yuoh is responsible for contributing to the management for the firm’s taxable-fixed income strategies with a multi-sector focus on investment grade assets.

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Glossary & Index Definitions

A basis point is one one-hundredth of a percentage point.

The Federal Reserve System (Fed) is the central bank of the United States and is governed by the Federal Reserve Board. The Federal Open Market Committee (FOMC), the policy-setting arm of the U.S. Federal Reserve, issues projections of the rate of U.S. economic growth at the conclusion of its meetings in March, June, September, and December of each year.

The federal funds (fed funds) rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.

Those with a hawkish view of monetary policy are focused on inflation. They favor raising interest rates to restrict the supply of money. Dovish monetary policy supports economic growth and aims to achieve maximum employment. It seeks to lower interest rates or keep them low, because loose monetary policy increases the money supply.

A risk premium is the return in excess of the risk-free rate of return that an investment is expected to yield.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

Yield is the income returned on an investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment's cost, current market value, or face value. Yield-to-worst refers to the lesser of a bond’s (a) yield-to-maturity or (b) the lowest yield-to-call calculated on each scheduled call date.

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. One such comparison involves the two-year and 10-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

The ICE BofA 1-3 Year U.S. Corporate Index is an unmanaged index comprised of U.S. dollar-denominated, investment-grade, corporate debt securities publicly issued in the U.S. domestic market with between one and three years remaining to final maturity.

The ICE BofA US Treasury Bill Index tracks the performance of U.S. dollar-denominated, U.S. Treasury Bills publicly issued in the U.S. domestic market. Qualifying securities must have at least one-month remaining term to final maturity and a minimum amount outstanding of $1 billion.

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