Christmas has come early for this asset class: What the Fed cut and RBA hold could deliver to investors

The Fed's decision to cut interest rates by 50 basis points was, to put it bluntly, an early Christmas present for fixed income investors. The dot plot, which demonstrates the Fed's own forecasts for where interest rates are likely to move in the future, also added an extra 50-75 basis points worth of rate cuts before the end of this year.

In my view, this messaging highlights three key considerations for investors:

1) The Fed’s focus has changed from inflation to employment. They will be patient when the data is good but any signs of negative data—especially concerning employment—are likely to trigger more aggressive cuts.

2) The Fed’s dot plot projections are not a guarantee. If economic data worsens, the market may start pricing in further rate cuts. This scenario reinforces the role of bonds as a key diversification tool in investment portfolios, offering stability during potential downturns.

3) Money will be on the move. As rates decline, we can expect a substantial redeployment of money from cash and money market funds into investments further along the risk spectrum, including bonds.

But what does this all mean for portfolio positioning? And what about Australian bond investors, who will have to wait a while longer for our first rate cut to hit the market?

In this month's Trade Floor update, we'll examine these key issues.

Edited Transcript

David Orazio: Hi and welcome to this month's trade floor update. Today I'm joined by portfolio manager Aaditya Thakur.

AT, let's start with the big news. The Fed has begun the easing cycle with a pretty big 50 basis point cut straight out of the gates. What's the rationale behind their decision and what are some of the implications for investors?

Aaditya Thakur: Yes, certainly Christmas has come early for the bond market. The Fed cut not only by 50 basis points, but they also slashed their year-end projections in their dot-plots by 75 basis points for 2024 and 2025, so taking their forecasted cash rate to around their estimate of neutral around 3% by early 2026.

I think the Fed have clearly stated a preference to try to stick this soft landing. And optimal policy dictates that they should go hard, go early, get policy down closer towards neutral, because we know that there are long monetary policy lags to feed through to the real economy.

So in terms of the implications for investors, I think there are three really important takeaways. Firstly, there's now this real asymmetry in the Fed's reaction function and for all central banks. They're going to be very patient through positive data but as soon as there's a hint of negative data they're going to cut pretty aggressively, especially if it relates to employment.

I think secondly, we have to remember that the market pricing and the Fed projections only take policy towards neutral. There's plenty of scope for the market to price in further cuts and take policy below neutral if the data were to worsen. And that means that bonds will continue to be that strong diversification anchor in portfolios.

And number three, I think, there's going to be a flow of fund effect. With the cash rate coming down quickly, the stockpile of money in cash, in money market funds, it's going to be redeployed out the risk spectrum into bonds, into credit and into risk assets.

So when you take all those three things together, that leaves us still positive on duration, we’re overweight duration and we’re positioned for further yield curve steepening. And we think that in the absence of a big data shock, volatility will be relatively contained.

Orazio: Now closer to the home we've had the RBA once again keep rates on hold. The big question is for investors when will the RBA join the global easing party? And what's some of the opportunities for domestic investors?

Thakur: Yes I think most economists now predict that the RBA will start a shallow easing cycle in February next year. And we think that that's pretty fair. We think that the macro cycle here has lagged the US by 6 to 9 months. So that lines up.

And secondly, I think by the time we get to February, we would have seen more progress on inflation and we would have seen a further loosening, of our labour market, which will enable that dovish pivot by the RBA.

I guess the good news for investors is that because the RBA have been relatively hawkish, compared to other central banks, bond yields haven't rallied quite as much as offshore. So yields are still very attractive. Ten year swap rates are at 4%, core bonds still yielding around 5%. There's still a great window of opportunity to lock in some really good yields, and still a lot of value in Aussie bonds.

And that's why from a portfolio positioning perspective, one of our highest conviction trades is still to be long Aussie duration, long Australian and New Zealand duration relative to offshore. And we continue to like that position.

Orazio: Thanks AT, appreciate your insights today. Now, as you've heard central banks have begun their easing cycle. With high quality bond portfolios generating north of 6% we believe there's a window of opportunity for investors to lock in elevated levels of yield, potentially benefit from capital gains, and hedge their portfolios against expected economic weakness.

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