Is 1% The New Zero?
We look for the Federal Reserve (Fed) to implement two more 25 basis point (0.25%) interest rate cuts before the end of the year, taking the Fed funds rate down to a range of 1.5–1.75%. In a vacuum, a lower Fed funds rate should support higher long-term yields as investors bet that policy will boost both demand and inflation. Given the U.S. economy’s resilience and the already low policy rate, we do not expect the Fed to take rates much lower than the 1.5% threshold. Indeed, policymakers want to ensure enough wiggle room to adjust rates further when a recession may appear more likely. In this scenario, a Fed funds rate of 1% could be the new zero, accompanied by other recession-fighting initiatives, including renewed quantitative easing programs.
Though we view the possibility of a negative Fed funds rate as unlikely, we’ve learned never to say never, particularly given the power of global money flows. Monetary officials in the United States are concerned with global economic and pricing stability, but Fed cuts may not be as effective in weakening the U.S. dollar if other central banks loosen policy even more. Unless the Fed takes further action, Treasuries could still be the main target in the worldwide hunt for yield, which would support bond prices and keep a lid on rates.
Conclusion
Considering the inclination of global central banks to loosen monetary policy, negative yields are likely to persist in many areas of the world. We look for the Fed to cut rates twice more, bringing the federal funds rate down to about 1.5%, providing some wiggle room should a potential recession require further policy easing. The combination of easier policy, economic fundamentals, and the widening budget deficit suggests to us the prospects for slightly higher market interest rates going forward. As a result, we will continue to favor investment-grade bonds and mortgage-backed securities for suitable investors when implementing the fixed income allocations within diversified investment portfolios.
John Lynch is chief investment strategist at LPL Financial.