Many investors are currently deciding whether to extend the duration of the fixed income part of their portfolios or wait until it is clear the Federal Reserve has stopped raising rates. Given that fixed income yields have risen this year, long-term forward-looking potential returns appear much better than in prior decades. We find that early on in Fed hiking cycles, cash (short duration fixed income) outperforms longer dated fixed income. As the tightening cycle ends, longer duration fixed income performance can easily reverse and then cash underperforms. In the few months before and 1-2 years after the Fed hit its peak policy rate in prior cycles, a diversified fixed income portfolio outperformed cash as shown below.
The big question now is: will the Federal Reserve need to raise interest rates further to bring down inflation that is still too high? If so, will the hike(s) be the last in the current cycle? The answer is likely the Fed is not done yet. The Fed has raised interest rates by 500 basis points since March 2022 to bring down the highest U.S. inflation in decades. In June, Fed policymakers decided to pause any rate increases to give themselves time to assess the effect of the previous increases. Fed policymakers are widely expected to deliver a rate hike at their meeting later in July, a move that would bring the Fed Funds policy rate to 5.25%-5.50%. What is less clear is whether they will raise rates at the September meeting, wait until November, or remain on pause and let inflation ease over a longer period of time. Fed Chairman Powell has not ruled out consecutive rate hikes to deal with higher than desired inflation. The personal consumption expenditures index has fallen from a peak of 7% last year to 3.8% in May 2023, but the current level is still almost twice the Fed’s desired 2.0% inflation.
There is a mix of views as to whether inflation has peaked or not. The New York Fed released a June survey recently on the state of consumer expectations that showed near-term inflation expectations dropped to their lowest level since April 2021. As such, the argument can be made that price pressure is weakening, which may cause the Fed to stop raising rates. However, the same survey showed a fifth straight month of expected home price gains, suggesting that housing inflation remains higher than desired. Yet higher rates may be needed because the economy has demonstrated strength even in the face of increases.
At Sunpointe, our view is that we are starting to extend duration on a small portion of the fixed income allocation but have not fully extended yet. Short-term treasuries still yield above 5% as of this writing, which is well above the yield on longer-dated maturities. Please let us know if you have any questions about this or any other topic related to your portfolio.
