Cuts to Interest Rates Will Be a Disappointment: What Does It Mean for Investors?

The Monetary Policy Shift: What to Expect in 2024

In 2024, major central banks were anticipated to make a significant monetary policy shift, with expected interest rate cuts that would lead to noteworthy decreases in the cost of money.
However, despite eagerly awaiting the first move by the ECB or Bank of England in early summer, something seems to be amiss, especially in the US.

The main central banks of advanced economies are now projected to retract less than half of the interest rate hikes implemented in the past two years — a perspective significantly reshaped by the outperformance of the United States.

According to new estimates from Bloomberg Economics, after the Federal Reserve, the European Central Bank, and the Bank of England collectively raised their benchmarks by 1,475 basis points, only 575 basis points of reductions are expected by the end of 2025.
What is truly about to happen in the markets in this renewed context, and how will it affect investments?

Interest Rate Cuts: Changing the Game for Investors

The latest insights, following a series of disappointing data on high US inflation alongside better-than-expected economic activity, are reshaping the investment landscape.

Bloomberg Economics’ macro-yield model in November suggested that 10-year Treasury yields would end this year at 4.1%.
Now, it points to 4.4%, marking a modest decrease from the current 4.65%.
According to Ana Galvao, the economist who built the model at Bloomberg, “downside surprises from inflation data at the end of 2023, followed by upside surprises since February,” have played a significant role in reshaping the outlook.

“The twists in monetary policy timing are always challenging, but the chaos caused by the pandemic and the unprecedented massive dose of fiscal stimulus since spring 2020 have made things even tougher,” stated Anne Walsh, chief investment officer at Guggenheim Partners Investment Management.

Walsh emphasized the anomaly of large deficits at a time of unemployment rates below 4%, complicating Jerome Powell and his colleagues’ mission to bring inflation back to 2%.
She expressed optimism in investment-grade bonds, citing sound underlying credit fundamentals and attractive yields ranging from 5.5% to 6.5%.
As of Thursday, the Bloomberg US Aggregate Index yielded 5.75%.

Derivatives trading is also showing a revamped perspective.
Only one 0.25-point rate cut by the Fed is fully priced in for this year, compared to at least five in early February.
Some options offer traders protection against another hike.

Northern Trust, overseeing about $1.2 trillion, expects a maximum of two Fed rate cuts in the latter half of this year and is heavily focusing on US high-yield debt, anticipating that the US central bank will manage to curb inflation without imploding the economy.
Yields for the Bloomberg US High Yield Corporate Bond Index exceed 8.2%.

“We are very neutral on every asset class, except high yield,” said Bahuguna in an interview in New York.
“High yield should fare well as there is a high coupon buffer and growth is slowing but still strong, so the default risk is low.”

Monitoring Central Banks’ Balances

The ongoing economic resilience — with the International Monetary Fund forecasting an acceleration rather than a slowdown in advanced economies this year — is expected to allow major central banks to continue reducing their bloated balance sheets accumulated during the Covid crisis.

The Federal Reserve, ECB, BoE, and Bank of Japan collectively expanded their balance sheets by a total of $9 trillion in 2020 and 2021.
By the end of next year, Bloomberg Economics now sees the group on track to reach a cumulative amount of around $3 trillion with quantitative tightening in 2024 and 2025, even after the Fed hinted at being inclined to slow the pace of QT by about half, starting shortly.

This implies that private sector investors will need to step in to absorb the supply of government debt.
Higher yields for a more extended period might still make this situation appealing.