Richard S. from Bend, OR asks: Good Morning Mitch, I’m sure many investors are looking ahead to the new year and thinking about different allocation ideas. My question is specifically about how the Federal Reserve and rate cuts could factor into your expectations for what performs well and what doesn’t. I look forward to your response and wish you a happy holiday season.
Mitch’s Response:
Thanks for writing! Thinking in terms of the Federal Reserve, 2023 was quite a year for investors who have been waiting for the arrival of higher-yield, risk-free options in portfolios. Yields on everything from long-duration Treasuries to money market funds, and even short-duration Treasuries pushed solidly higher, especially over the summer months.
Investors took notice and also took action. According to Federal Reserve data, money-market funds and high-yield savings accounts saw big inflows in Q2, with $651 additional dollars compared to Q2 2022. For many investors, a risk-free return of 4% to 5% was more than acceptable, especially given the paltry yields of the previous decade.1
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But I think it’s important for investors to remember that while 4% or 5% seems quite attractive – especially relative to a prolonged period of near-zero risk-free yields – it’s the real return that matters most. In other words, a risk-free return should be adjusted for inflation in order for an investor to fully gauge how well they did. Inflation has come down substantially over the past twelve months but is still running at 3% year-over-year. As seen in the chart below, that means the inflation-indexed yield on a 10-year Treasury bond is closer to 1.5%, which isn’t so attractive.
Yield on 10-Year Treasury Bond, Adjusted for Inflation
In your question, you ask what the Federal Reserve’s ‘pause’ and potential rate cuts in the new year could mean for asset allocation ideas. We’ve already started to see some impact in both the fixed-income and equities markets, with both rallying strongly over the past few weeks. Remember, when bonds rally, it means prices are rising but also that yields are falling. For fixed-income investors with long time horizons, hopefully, you were able to lock in higher yields from the summer months. But otherwise, it probably makes sense to be nimbler in fixed income, investing on the shorter end of the curve, especially given our expectation that interest rates could be lower in the future.
From an equity perspective, a Fed ‘pause’ and the months leading up to rate cuts have historically been good for stocks. Since 1990, stocks (S&P 500) purchased six months after the Fed’s first-rate cut delivered an annualized average of 15%. While that’s quite good, buying stocks before the rate cuts – or said another way, during the ‘pause’ – paid off even more, delivering a 21% annualized average return.
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Disclosure
2 ZIM may amend or rescind the free guide offer, Using Market Volatility to Your Advantage, for any reason and at ZIM’s discretion.
3 Fred Economic Data. December 15, 2023. https://fred.stlouisfed.org/series/DFII10#
4 ZIM may amend or rescind the free guide offer, Using Market Volatility to Your Advantage, for any reason and at ZIM’s discretion.
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