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Will Interest Rate Cuts by the Fed Impact Bond Portfolios?

At the end of August, the Bureau of Economic Analysis released new personal consumption expenditures index data showing that inflation has likely slowed enough for the Federal Open Market Committee (FOMC) to cut interest rates at next week’s highly anticipated meeting.

Now, many investors may be wondering whether they should adjust their bond allocations depending on the timing and pace of the expected rate cuts. Our research shows that it’s difficult to draw actionable conclusions from Fed watching. Per Exhibit 1, evidence shows that bond markets may move ahead of the Fed because markets continually process information that might factor into Fed decisions.

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Small Value Roars Back

It’s only been a couple months since I was encouraging patience with small cap value based on past examples of quick turnarounds in relative performance. At the risk of sounding like a rooster taking credit for the dawn, I am comfortable saying that July’s US small cap value resurgence was a welcome development.

This story has been deservedly covered in the media, and here are my favorite stats for performance of small value versus large growth based on returns for the Russell 2000 Value Index and Russell 1000 Growth Index.

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Japan in the News, But It’s Nothing New

Japan’s stock market has been in the news lately for setting “a new market high.” While its stock market did exceed the 1989 high-water mark, this strains the definition of “news.” Using a market-cap-weighted index that includes dividends, that threshold was cleared back in May 2017.

Japan’s stock market history is an important talking point but for a different reason: the prospect of a market going decades without a positive cumulative return. Many investors, who expect the US stock market’s recent dominance to continue, have questioned the benefits of global diversification. They would do well to view Japan as a cautionary tale. I doubt many investors in the late 1980s would have expected the broad Japanese market to go nearly three decades without a new high. Even some of the concerns about Japan in 1989—high valuations, top-heavy performance—resemble today’s concerns about the US market.

History says it’s challenging to pick which countries will outperform. Japan’s experience suggests there’s a lot of uncertainty around individual markets. Global diversification helps mitigate that uncertainty.

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Don’t Get Fed Up

One of the reasons why Fed watching is an unreliable input into investment decisions is because the Fed’s expected actions are already reflected in market prices. By the time the Fed executes rate changes, markets have already had time to form an expectation and may not need to react any further.

It’s also important to note there’s variation in market interest rates that is unrelated to changes in the Fed funds rate. For example, the Fed’s target range has remained constant over the past year. Meanwhile, the 10-year Treasury yield has fluctuated over this period, falling in the last quarter of 2023 before rising again this year.

This is a good example of why it’s hard for investors to draw actionable conclusions from Fed watching. The returns on your bond portfolio are likely not that closely correlated with the Fed funds rate. And unless you looked up future Treasury yields while out in your DeLorean, it's unlikely you will be able to consistently outperform markets through interest rate predictions.

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