Savers and investors can be forgiven if they are suffering from an extreme case of whiplash.

Not long ago, they were counting on higher interest rates after years of near-zero returns on cash. Seemingly overnight, the conventional wisdom reversed. Markets are now betting that interest rates are about to fall for the first time since December 2008.

Federal-funds futures markets are pricing in a half-point cut this year, and another 40 basis points in 2020; a basis point is equal to one-hundredth of a percentage point. The so-called yield curve has also flattened and inverted: Short-term Treasuries are yielding more than 10-year bonds, and there is scant difference between the yield of a one-year T-bill (2.04%) and a 10-year note (2.12%). Historically, that has often indicated a recession is coming, implying that a rescue plan from the Federal Reserve may be on the horizon.

Expectations for interest-rate cuts have jumped with the escalation of President Donald Trump’s battles over trade and data indicating the economy is slowing. U.S. gross domestic product is tracking at a 1.5% growth rate this quarter, according to the Federal Reserve Bank of Atlanta, well below the 3.1% annualized pace of the first quarter.

The president has been badgering the Fed to lower rates for months, and his latest threat—to slap 5% tariffs on $350 billion worth of imports from Mexico—may have upped the ante, forcing the Fed’s hand. James Bullard, the dovish president of the Federal Reserve Bank of St. Louis, said on Monday that a rate cut “may be warranted soon.” Fed Chairman Jerome Powell said in a speech on Tuesday that the Fed is watching trade developments closely and will “act as appropriate to sustain the expansion.”


It’s going to be a bumpier ride because of tariffs, but the bar for rate cuts remains fairly high.


—Jerome Schneider, Pimco

If the markets are right, rates could fall by three-quarters of a point over the next year, taking federal funds to a range of 1.5% to 1.75% from their current 2.25 to 2.5%. That would have wide-ranging consequences for stocks, bonds, and savings vehicles like money-market funds.

Here’s a guide for what to expect, and some moves to consider.

Are rate cuts really coming?

Predicting the Fed’s next move isn’t easy under normal circumstances—and even harder in today’s political climate. Trade issues complicate the economic calculations. And the Fed is under a political cudgel: policy makers want to preserve the Fed’s political independence and credibility, and they want to maintain some dry powder in the event of an external shock like a geopolitical or financial crisis. In late May, Fed Vice Chairman Richard Clarida cautioned the markets about cuts related to temporary setbacks like trade or soft inflation data. “We should allow the data on the U.S. economy to flow in and inform our future decisions,” he said in a speech in New York.

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Some strategists and bond managers are skeptical that the Fed will follow through with rate cuts. “I don’t think we’ll see lower rates,” says George Pearkes, macro strategist at Bespoke Investment Group. Rates have fallen partly because of technical factors like momentum trading and short-covering by speculators who had positioned wrongly for higher rates, he says. Fed officials have stressed that they will be patient and data-dependent, and nothing has really changed in their latest commentary, he adds. Taking the data as given, he told clients this week that the market has gotten ahead of the data.

Jerome Schneider, head of short-term portfolio management at Pimco, says it’s reasonable to assume some monetary easing in the face of a slowing economy and trade friction. But “the market is now fully pricing in a recession scenario, and we’re not there yet,” he says. “It’s going to be a bumpier ride because of tariffs, but the bar for rate cuts remains fairly high.”

Goldman Sachs

concurs. Financial conditions have tightened modestly, but growth and employment trends still look healthy, the firm’s chief economist, Jan Hatzius, wrote in a note this past week. Inflation data don’t warrant a cut, and if the Fed eases up based on flimsy financial evidence, it would “look overly political in light of President Trump’s vocal demands for easier policy.” Hatzius increased his expectations for cuts in the third and fourth quarters but still only pegs the odds at 28% and 31%, respectively.

Nonetheless, the markets have priced in a few cuts, and if the Fed falls short, investors could see a selloff in stocks and yields heading down again—precisely the outcome the Fed wants to avoid.

“What really matters is why the Fed decides to cut,” says Jim McDonald, chief investment strategist for Northern Trust. “If it’s as insurance against a recession and leads to a steeper yield curve, then that’s positive for risk taking. If it’s a firefighting episode, that will lead to a flatter curve and risk-off environment.”

Say goodbye to 2% savings yields.

Money-market funds holding short-term commercial paper and government securities would quickly yield less if the Fed cuts rates. Yields would also fall for checking and savings accounts. Retail money-market funds now yield an average 2%, according to Crane Data. Online savings accounts tend to pay a bit more. Salem Five Direct recently advertised a 2.51% yield on savings with a $100 minimum balance. BBVA Compass accounts yield 2.4% with a $10,000 minimum.

Those yields might edge back down to 1% in a falling-rate climate. That would sting, but if rates fall because of recession fears, stocks and other “risk assets” may get cheaper. That would open opportunities to invest at lower valuations, says Jim Grant, editor and publisher of Grant’s Interest Rate Observer and a Barron’s contributor. “The reason for holding cash isn’t the trivial rate of interest you’re earning,” he says. “It’s the flexibility that cash affords you when Mr. Market puts things on sale and opportunity knocks.”

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Either way, low rates make it tougher to generate a real, inflation-adjusted return from savings accounts. With inflation at about 1.5%, savings yields are small in real terms. Certificates of deposit yield a little more, but the trade-off is a lack of liquidity until the CD matures. And it doesn’t pay to buy longer-term CDs. According to Bankrate.com, the highest rates on five-year CDs are about 3.1%, scarcely above the 2.8% rate on a one-year CD.

Fixed income gets trickier.

Bond investors have enjoyed quite a ride since last fall: Yields have fallen while prices have climbed, generating profits for investors all along the curve. That party could end, however. Short-term bonds have rallied so much that the Fed would have to cut rates quite aggressively to generate more price gains, says Pearkes. Long-term yields have also slumped. And the next move may well be up: Yields could increase if the market senses that Fed cuts will be stimulative to the economy and inflation expectations.

Another challenge in the bond market: Investors aren’t being compensated much for credit risk. The spread, or difference in yields, between investment-grade corporate bonds and Treasuries has declined sharply since 2016, though it has edged up lately. Yields could keep climbing if inflation picks up with stimulative rate cuts. Another risk is that credit quality takes a hit: About half of the investment-grade market is rated BB—just above the ceiling for junk. In a slowing economy, firms may lose their investment-grade ratings, pushing prices down as funds that can’t own junk are forced to sell.

*30-day SEC yield

Source: Company reports

Similarly, there isn’t much value in junk bonds. Spreads are about 450 basis points, down from 850 in early 2016 and well below the 560-point average historically, according to Marty Fridson, a high-yield expert and chief investment officer at Lehmann Livian Fridson Advisors. The junk default rate is 2%, well below average, and it might rise if the economy continues to slow, creating a headwind for junk bonds. A rate cut would be favorable, he says, “but don’t look for huge moves in high-yield.”


“Companies that are focused on cash-flow generation and have competitive positioning will do perfectly fine.”


—Jonathan Golub, Credit Suisse

Given the risks of yields moving in either direction, Pearkes says that investors should play it safe by sticking with the “belly” of the yield curve: Treasuries with five-year maturities. Short-term bonds are now pricing in rate cuts and could sell off if the Fed doesn’t follow through, he says. And because yields have already slumped, there isn’t much upside if the Fed does cut. Long-term yields could rise, he adds, in anticipation of higher inflation—which is what the Fed would want with rate cuts.

Another pocket of value is agency mortgage-backed securities, or MBS, says Andrew Szczurowski, a portfolio manager on
Eaton Vance
’s
global income team. Spreads for agency MBS have widened this year despite tightening that has occurred in credit markets. One of the main drivers is the Fed, which is allowing up to $20 billion of agency MBS to roll off its balance sheet each month through prepayments. But the securities are rated AAA, implying virtually no credit risk due to their backing by the federal government. Szczurowski expects them to shine in a tougher economic climate. “I would expect them to outperform lower credit assets as you start getting a flight to quality and money flows into this area,” he says. “You can get more yield in agency MBS than a AA-rated corporate bond. That isn’t normal.”

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Schneider, the Pimco fund manager, says that investors “should remain liquid and nimble.” High-quality short-term funds are yielding 2.75% to 3% and would be “defensive in an uncertain environment.” The funds don’t take a lot of interest rate or credit risk, he adds, and they’re a way to “safeguard capital while earning attractive income.”

How to invest for lower rates.

The stock market’s reaction hinges on the outlook for the economy and corporate profits. If trade frictions worsen, tighter financial conditions could emerge as lending activity and confidence dry up. Market returns also depend on whether companies absorb higher trade-related costs, pinching their profit margins, or pass them on to consumers. It’s also unclear whether the Fed’s remedy of lowering rates will do the trick, steepening the yield curve and stimulating economic activity and inflation.

Jonathan Golub, chief U.S. equity strategist for
Credit Suisse
,
says the markets will need “better economics” to move higher in the near term, making him cautious about buying trade-related dips. But investors with a two-to-three year horizon should stick with growth over value and the U.S. over emerging markets, he says. Domestically, he likes the health-care sector for its secular growth, and tech companies focused on software, internet retail, and services. “Companies that are focused on cash-flow generation and have competitive positioning will do perfectly fine,” he says.

A steeper yield curve would benefit financial firms that profit from the so-called carry trade, or borrowing at short-term rates and lending at higher longer-term rates. Mortgage real estate investment trusts would be winners, says Pearkes. And banks would do well; they’ve been hurt by a flat curve and would see net interest margins improve if the short end of the curve drops while long rates rise.

Global REITs would also be good candidates for outperformance, says McDonald, and they have been outperforming since early April. He also likes industrials and tech—sectors that would benefit from a stronger outlook for economic growth—assuming the Fed goes along with that plan.

Write to Daren Fonda at daren.fonda@barrons.com



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