After Pricing in a Recession, the Bond Market Gets a Wake-up Call From the Fed

On Wednesday, the Federal Reserve took a significant step to lower borrowing costs for the first time in four years. This marked the first interest-rate cut since 2020, with the central bank reducing its short-term policy rate by half a percentage point. The target range now stands at 4.75% to 5%.

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However, this move did not fully satisfy Wall Street. Longer-term Treasury yields, which influence the pricing of various loans like auto and mortgage loans, began to rise after hitting their lowest levels earlier in the week. Despite the Federal Reserve's aggressive initial rate cut, the message it sent about future actions left investors wanting more.

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Cindy Beaulieu, Chief Investment Officer for North America at Conning, which manages around $160 billion in assets, remarked that rates had declined too much and too quickly across the yield curve. Although the 50 basis-point rate cut was unexpected, Beaulieu pointed out that Fed Chair Jerome Powell used his subsequent press conference to signal a cautious stance on further rate reductions.

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Powell described the cut as "the beginning of this process," emphasizing that the Fed intends to proceed cautiously in future meetings. "We can make a good strong start. And I’m very pleased that we did," he said. While some investors may have hoped for a more aggressive approach, Beaulieu viewed this measured strategy as sensible, given the relatively strong economy and resilient consumer spending. In her view, the upward movement in longer-term rates is justified.

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The 10-year Treasury yield rose by 4 basis points to 3.685% as of 3 p.m. Eastern time, rebounding from its yearly lows. Beaulieu expects the 10-year yield to surpass 4% by year-end, potentially reaching 4.25%. She noted that while the market seems to be pricing in a soft landing, the rapid decline in rates may indicate a greater risk of recession.

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Since the Federal Reserve began raising rates in 2022, volatility in the bond market has been high, leading to historic losses and creating turbulence across financial markets. Although inflation and rate hikes no longer pose the same level of threat they did two years ago, the rates market remains sensitive to shocks that can negatively impact investment portfolios.

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Karen Manna, a fixed-income portfolio manager at Federated Hermes, which manages about $780 billion in assets, observed that both bond and equity markets have occasionally moved ahead of economic reality. "We all want to look ahead and see around the corner. But we can’t predict what happens with the economy," Manna told MarketWatch.

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With the economic outlook still uncertain, particularly if the housing market gains momentum, Beaulieu is cautious about extending the duration of bond portfolios. She is also skeptical that the Fed will be able to bring inflation back to its 2% target, especially if it continues to lower rates. She does anticipate a widening of spreads—the extra yield earned on bonds with credit risk—especially as the November presidential election approaches.

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Manna also stressed the significance of the upcoming election, which will likely be a focal point for investors now that the initial rate cut has occurred. She warned of a prolonged period of uncertainty regarding both the Federal Reserve's future actions and market reactions. Manna emphasized the importance of monitoring liquidity within portfolios to avoid becoming trapped in illiquid asset classes and then being forced to make unfavorable moves.

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Despite the Fed's rate cut, stock markets ended the day lower, yet remained near record levels. The Dow Jones Industrial Average fell by 0.3% to 41,503, the S&P 500 dropped by 0.3%, and the Nasdaq Composite closed down by 0.3%, according to FactSet data.

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The Fed's decision has left markets in a complex state. While the initial rate cut was larger than many anticipated, the central bank's cautious approach moving forward has created uncertainty. Investors now face a delicate balance, navigating potential market volatility and a shifting economic landscape as they prepare for both the Fed's next moves and the upcoming election.

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