Federal Reserve: On the Road Again

Moreover, the leading indicators of inflation are pointing to further declines. Wholesale prices for raw materials such as energy and industrial metals are falling sharply as global demand slows. China's economic slump has led to a broader slowdown that has spread to Europe and some emerging-market countries. While U.S. gross domestic product (GDP) growth has remained firm in the 2.5% to 3.0% region, global growth is pulling inflation lower.

A slowdown in employment growth is another factor propelling the Fed toward easing. The pace of job growth has slowed substantially, and the unemployment rate has risen since last year. A rising unemployment rate is a key indicator for the Fed in setting policy. At 4.2% the overall unemployment rate is still low, but the increase from 3.4% is a worrying sign that the economic conditions are deteriorating.

Will the Fed take the express lane?

With a rate cut at the September 17-18 Federal Open Market Committee (FOMC) meeting a foregone conclusion, the question now is, "How quickly will the Fed move?" The target range for the policy rate—the federal funds rate, which is the rate banks charge each other for overnight loans—is currently set at 5.25% to 5.5% with inflation near 2.5%, leaving plenty of room for the Fed to lower rates.

We would argue that the Fed could start the cycle by cutting the fed funds rate by 50 basis points (or 0.5%) and then moderating the speed depending on conditions. However, in past cycles, the Fed has cut rapidly when the economy was in recession or in crisis, such as the pandemic. A fast cycle might be defined as when the Fed cuts five times in a year's time. That has only happened in recessionary or crisis periods. Currently, the economy is not in recession or crisis, but the Fed is trying to avoid a recession. In cycles when the Fed is cutting in response to falling inflation, the pace has been moderate.

Direction more important than speed

While the pace matters, it's the direction of travel that is most important for investors. Bond yields are falling and are likely to continue to move lower as the rate-cutting cycle begins. Based on the current structure of the Treasury yield curve, we see more room for short-term rates to fall than long-term rates. The yield spread between two-year Treasuries and 10-year Treasuries has recently moved from steeply inverted to slightly positive.

While we continue to suggest that investors with a high allocation to cash or short-term bonds should consider extending duration, we would look beyond the Treasury market to do so. We look at the Bloomberg U.S. Aggregate Bond Index as a benchmark. It has a current yield-to-worst (the lowest possible return on a bond with an early-retirement provision, barring default) of 4.2% and a duration of 6.1 years. For most investors, a duration in that region would allow for capturing attractive yields over an intermediate time frame while mitigating volatility.

But we favor staying in higher-credit-quality bonds for the majority of a portfolio. Investment-grade corporate bonds and government agency bonds currently offer yields in the 4.5% region with durations of about six to seven years, which is about 75 to 100 basis points higher than Treasury yields of similar duration.

In addition, investment-grade municipal bonds can offer attractive tax-equivalent yields for investors in high tax brackets. For investors willing to take more risk, a small allocation to preferred securities could make sense, but volatility is likely to be high.

All roads appear to lead to lower rates

With the Federal Reserve and most major central banks in easing mode and treasury yields well above the inflation rate, the direction of travel for rates appears lower. Despite the strong bond market rally over the past few months, we still see room for yields to fall further. This road trip isn't over yet.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Past performance is no guarantee of future results, and the opinions presented cannot be viewed as an indicator of future performance.

Investing involves risk, including loss of principal.

Supporting documentation for any claims or statistical information is available upon request.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

Preferred securities are a type of hybrid investment that share characteristics of both stock and bonds. They are often callable, meaning the issuing company may redeem the security at a certain price after a certain date. Such call features, and the timing of a call, may affect the security's yield. Preferred securities generally have lower credit ratings and a lower claim to assets than the issuer's individual bonds. Like bonds, prices of preferred securities tend to move inversely with interest rates, so their prices may fall during periods of rising interest rates. Investment value will fluctuate, and preferred securities, when sold before maturity, may be worth more or less than original cost. Preferred securities are subject to various other risks including changes in interest rates and credit quality, default risks, market valuations, liquidity, prepayments, early redemption, deferral risk, corporate events, tax ramifications, and other factors.

Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and the Schwab Center for Financial Research does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Mortgage-backed securities (MBS) may be more sensitive to interest rate changes than other fixed income investments. They are subject to extension risk, where borrowers extend the duration of their mortgages as interest rates rise, and prepayment risk, where borrowers pay off their mortgages earlier as interest rates fall. These risks may reduce returns.

The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.

The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.

Schwab does not recommend the use of technical analysis as a sole means of investment research.

There are risks associated with investing in dividend paying stocks, including but not limited to the risk that stocks may reduce or stop paying dividends.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Commodity-related products carry a high level of risk and are not suitable for all investors. Commodity-related products may be extremely volatile, may be illiquid, and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions.

Indexes are unmanaged, do not incur management fees, costs, and expenses and cannot be invested in directly. For more information on indexes, please see schwab.com/indexdefinitions.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Source: Bloomberg Index Services Limited. BLOOMBERG^® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). Bloomberg or 'Bloomberg's licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg's licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

0924-RZ09

---

A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out some of our webcasts.

© Charles Schwab

More Emerging Markets Topics >