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The Start of Fed Rate Cuts: Challenges and Opportunities for Liquidity-Minded Investors
As the Fed contemplates rate cuts, investors may face new considerations for managing liquidity and returns.
- Portfolio Construction
- Fixed Income Insights
- Markets & Economy
- Cash
Key Points
What it is
We explore the potential impacts of expected rate cuts, focusing on how they may affect liquidity management strategies for investors.
Why it matters
With rate cuts potentially leading to declining yields, liquidity-minded investors may choose to assess their cash holdings and short-term investments.
Where it's going
Broad market trends suggest a shift toward diversified liquidity strategies and a reevaluation of ultra-short fixed-income options, reflecting expectations of ongoing Fed rate cuts.
The market is currently pricing in a Fed rate cut on September 18. We anticipate a 25- cut. With inflation closing in on the Fed’s 2 percent target and the labor market still healthy, the start of the rate-cutting cycle will likely be good news for the U.S. economy. Now, rate cuts may pose challenges to liquidity-minded investors, but there are ways to potentially mitigate the effect of declining yields on one’s cash reserves. Let’s take a closer look.
In recent years, with money market yields elevated and the yield curve inverted, the perceived cost of holding excess liquidity may have seemed relatively low. If economic conditions evolve broadly as we anticipate, however, shorter-term yields will likely fall significantly, and the curve will likely dis-invert. So now would be a good time for the size and composition of their cash reserves.
Let’s look first at the composition of cash reserves. Direct holdings of money market instruments—such as —that are not sufficiently diversified across the maturity spectrum may be subject to abrupt declines in yields when the Fed begins cutting rates. In contrast, a well-diversified money market fund that is invested in a wide range of maturities may help ease the sting of declining yields.
History suggests that, when the Fed starts cutting rates, investors potentially benefit from moving a portion of their cash not already earmarked for short-term or operational needs to fixed-income strategies. These strategies add only limited exposure to interest-rate risk because they typically focus on bonds maturing in three years or less. And they potentially generate favorable risk-adjusted returns by including holdings of high-quality short-term corporate bonds and asset-backed securities.
One last point before we close: While we agree with the market on the timing of the first Fed rate cut, we believe economic conditions may warrant a more gradual pace of rate cuts than currently priced in. For instance, unlike the market, we view the bar for a 50-basis-point cut this month as very high. More generally, the effects of cuts on the front end of the curve may not be as pronounced as the market currently anticipates. But this is a topic for another day.
A basis point is 1/100th of 1%, or 0.01%. Basis points often are used to quantify interest rates, bond yields and investment returns.
Funds that invests in securities with very short durations or maturities.
A Treasury bill is a loan to the U.S. government that matures in three, six or 12 months.
Main Point
Navigating Fed Rate Changes: Considerations for Liquidity-Minded Investors
As the Fed considers cutting rates, liquidity-minded investors may want to consider diversifying maturities and reassessing cash reserves to navigate the potential challenges of falling yields.
Antulio N. Bomfim
Head of Global Macro – Global Fixed Income
Antulio Bomfim, head of global macro for the global fixed income team, oversees interest rate strategy, systematic volatility, liquidity and monitoring of systemic risk globally. He is also responsible for the firm’s global liquidity management business.
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