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Written by: JB Golden | Advisor Asset Management
With a scant seven business days left until the Federal Reserve likely embarks on the first easing cycle since the pandemic in 2020, it remains vexing that well over $2 trillion of retail cash remains invested in money market instruments alongside roughly $4 trillion in corporate coffers. The $6.24 trillion in money market to end August was an all-time high. The continued in-flows into cash and cash alternatives are even more interesting when one considers the bond market has been all but screaming at investors in recent months to get off their cash. Those investors that could be considered early have already been rewarded with strong performance across the breadth of fixed income markets over the summer months. Reinvestment rate risk is easy to miss as it hides out under the ambiguous concept of opportunity cost making it difficult to grasp, but with a move by the Fed likely coming in short order, idle cash is likely to bear the brunt of lost opportunities further out the yield curve. It is counterintuitive for most investors to take slightly less yield and slightly more risk to move out of cash but investors who remain invested in money market too far past the first Federal Reserve cut could be missing the opportunity to lock-in attractive long-term yields. It conjures images of the age-old Wendy’s commercials, “Where’s the Beef?” Investors who wait too long to hit the exit on money market could be left wondering, “Where’s the yield?” in short order. The “T-Bill & Chill” (Treasury Bills) strategy, as Jeffrey Gundlach so eloquently put it, has been a successful play for investors over the last couple of years. It has allowed for some of the most attractive yields in the market while providing some air cover against the most volatile interest rate environment in recent memory. That said, it is likely time to reconsider T-Bills as the last chance to be considered ahead of the Fed is quickly approaching.
Fixed income markets have had a great summer and should have served as a signal for most investors to begin locking in elevated yields a bit farther out the yield curve. U.S. Treasuries were up 4.63% over the three-month period ending August 30, 2024, with the longest duration areas of the curve up over 7.5%, outpacing the S&P 500 over the same timeframe. U.S. Investment Grade Corporates were up 4.53% over the summer, U.S. High Yield, already having the best year of any U.S. fixed income market, posted 4.16% and U.S. Municipals, while lagging at 2.86%, produced the best three month stretch since 2021.
The summer rally seemed to be screaming at bond buyers to “get off your cash.”
Data, especially on the labor front, to end spring and start the summer, showed a softening at the margins. While this likely resulted is some flight to quality, safe-haven buyers concerned about a slowdown or recession, the bigger driver for fixed income remained a market focused on the Fed. The weakness in labor was noted by the Federal Reserve and messaging from Fed officials began to show a renewed focus on the employment pillar of their dual mandate. By the end of the summer at Jackson Hole on August 23, Fed Chair Jerome Powell made it more than clear the Fed had more concern over labor than inflation stating, “We do not seek or welcome further cooling in labor market conditions” — all but cementing a rate cut in September. The latest non-farm payroll report released last Friday missed expectations and included prior month revisions downward possibly keeping a 50bps (basis point) hike on the tables leaving the only remaining question not “If?” but “How much?” U.S. Treasury markets enter September with over four cuts priced in by the end of the year with only three meetings remaining, which might be slightly aggressive, but should be heeded nonetheless.
The shifting shape of the yield curve also seems to confirm that much of the recent strength in fixed markets is a forward pricing response to an upcoming inflection point in Fed policy. The 2-Year U.S. Treasury (TSY) — one of the most sensitive areas of the curve to Fed policy — has fallen over 120bps since late May. The rally in the 2-Year TSY culminated last week in the dis-inversion in the 2s-10s (2-year Treasury vs 10-year Treasury) spread. For the first time in two years, the 2s-10s spread is positive and the move in the 2-Year TSY is yet another indication, in our view, it is time to reduce cash allocations. While the 3 month–10-year spread remains inverted, it will likely be the last domino to fall as markets normalize to a positively sloped curve.
If the move in the 2-Year is not enough to get investors off the sidelines and out of cash, then look no further than recent moves in the 3-month T-Bill with a yield that has been pegged between 5.25% and 5.50% since March 2023. Markets began to forward price expectations the Federal Reserve would reach a Fed Funds target of 5.25% to 5.50% in March 2023, and by July 2023 the Fed delivered what is almost certainly the last rate hike of this cycle moving the target range up to 5.25% to 5.50%, in lock step with the 3-month T-Bill. Fast forward to 2024, and almost like clockwork, roughly 90 days ahead of what is expected to be the first rate cut, the 3-month T-Bill yield began a descent that left it at approximately 5% to end last week. When considered in light of the Fed Funds target rate, 5% is a very interesting handle for the 3-month Treasury. It represents roughly 50bps of cuts from the 5.50% level in June and it happens to straddle the line between a Fed Funds target range that could represent one cut to a range of 5.25% to 5.00% or two cuts to a range of 5.00% to 4.75%. This process of forward pricing expectations of Fed policy is likely to continue to drag cash rates lower with the pace being dependent on how fast the Fed cuts rates.
While a very volatile measure apt to change at moment’s notice, Fed Funds futures are currently pricing an implied Fed Funds rate of 4.15% to end 2024, and this gives some guidance as to where the 3-month T-Bill yield might be heading in the coming months. This is meaningfully lower than currently obtainable yields in many other areas of fixed income. This is the large silver lining of the current bond market. Cash rates will likely be the last to fall, and while it seems they might be coming down in short order, we believe there remains a window of opportunity to get out of cash. From short duration high yield to intermediate investment grade corporates, all the way to higher grade tax-exempt municipals, the Fed has truly put the income back in fixed income.
Take heed of the market’s messaging the last several months as a call to action, because we could be quickly approaching the last call to get ahead of the Fed.
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