Bond markets reacted emphatically to the Federal Reserve Board signaling yesterday that, despite skipping an immediate interest rate hike in September, it needs to keep rates higher for longer.
Benchmark two-year Treasury yields rose to 5.157% in overnight trading—a 16-year high—with 10-year notes hitting 4.433%, as equity markets slumped.
Advisors should take that as a signal that they need to start making some decisions about how much to keep in cash, said Joe Boyle, fixed income project manager at the Hartford Funds.
“We expect cash to get outpaced by higher quality bonds,” Boyle said in an interview.
After years of earning almost nothing, money markets paying 5% and some CDs paying nearly 5.5% have become prized by investors.
But there is a better deal in higher quality bonds, which are already paying 5.25%. And for advisors and investors more comfortable with risk, quality high-yield and emerging market bonds are paying 7% to 10%, Boyle said.
There are myriad bond strategies, “but right now I’m in the high-quality camp. They are going off at 5.25% right now. In cash, the thought is you’re liquid, but if we go into a recession the rates will go down and that will be hairy,” Boyle warned.
Threats to money rates include not only future Fed rate hikes, but consumers’ growing reluctance to spend and economic woes weighing down China, which may not be able to prop up the global economy as it has during recessions in the past, he noted.
“The reality is right now when I look at high-quality bonds on [the Barclays Aggregate Bond Index] they’re at a 90% or more discount, and these are default remote secure bonds, so you can feel comfortable that over time you’ll get the coupon and some capital appreciation, provided there isn’t a huge uptick in defaults. But it’s going to take some patience,” Boyle said.
The Fed’s hawkish lean wasn’t missed by the markets, he said. “Whether they’ll be one or more hikes, they put it out there that they’re definitely willing to do it. [Fed Chairman Jerome] Powell said he’s more than willing to put us into some sort of recession in order to stabilize prices and maybe dig us out of the hole we’ve been in for the past three years,” Boyle said.
With another quarter point on the table “rates are definitely trending up again this morning. We’re hitting highs we haven’t seen in quite some time. But personally, I think there’s a cap on this. Is 5% in the cards? Perhaps. But I’m worried about what’s on the other side if we hit 5%,” he said.
The smart money and banks won’t catch the falling knife, Boyle said. They took awhile to ratchet rates up on money, but they’ll lower them pretty quickly, so for those keeping tidy sums in cash right now, it will become a timing issue of when to diversify to safer ground.
“Cash is still very attractive, but at some point I think you’re going to time the market if you’re going to stay in cash," he said. "If you’re saying ‘Well, there’s one more hike left,’ OK, that’s only an additional 25 basis points. We’ve already seen 500 basis points of hikes."
Cash and high-quality bonds are generating a similar amount of income right now, but what you don’t have with cash is “an already baked-in, significant amount of capital appreciation that cash doesn’t. Cash will drop,” Boyle said.
If the U.S. economy does take an economic downturn, whether it’s from recession, fallout from China’s economic woes or the steep downturn in commercial real estate, those who hold on to too much cash too long “will experience a double whammy of falling rates today and in the future, reinvestment risk,” he warned.