Investment Strategies in a Declining Interest Rate Environment

Morningstar Research – December 10, 2024

Where to Find Returns When Interest Rates Fall

As inflation trends downward and global cash rates are poised to decline, investors face the challenge of repositioning the fixed-income portions of their portfolios. The experts at Morningstar Research, including Dominic Pappalardo and Preston Caldwell, delve into the strategic approaches for US Treasury, corporate bond, and international bond exposures in this evolving economic landscape.

A Look at Federal-Funds Rate Forecasts

The Federal Reserve began cutting interest rates in September 2024, moving away from the elevated 5.25%–5.50% federal-funds rate maintained since July 2023. This shift comes as efforts to combat high inflation have largely succeeded. Morningstar’s economic team anticipates further reductions, with expectations of the rate falling to 4.25%–4.50% by the end of 2024, 3.00%–3.25% by the end of 2025, and 2.00%–2.25% by the end of 2026. This trajectory suggests a substantial drop in the income generated from bank deposits.

US Investors: The Predicament of Holding Cash

Holding cash has been a safe strategy for many investors, but it doesn’t make a significant contribution to returns, especially in a declining interest rate environment. Cash deposits have continued to remain high, with money market fund assets reaching \$6.51 trillion as of October 2024. Despite the declining benefits of cash, many investors have not yet reduced their cash holdings since the pandemic.

US Treasuries: Opportunities in Longer-Term Bonds

For those invested in US Treasuries, the potential decline in interest rates presents an opportunity. Longer-term bonds, such as the 10-year Treasury yields at 4.3%, offer an attractive return compared to cash. As the fed-funds rate is expected to average 2.3% over the next decade, the appeal of these longer-term investments becomes evident. The potential for price appreciation and higher income makes them a compelling alternative to cash.

Corporate Bonds: Evaluating the Risk-Reward Balance

Corporate bonds, however, present a more complex scenario. Despite the low returns for the additional credit risk, current valuation levels are historically extreme. Investment-grade corporate bond spreads are at their 16th percentile tightest level, a situation not seen since 2021. High-yield bonds are even more compressed, with spreads at the sixth percentile tightest level in history. This tightness suggests limited upside potential and significant downside risk should economic conditions worsen.

Global Bonds: Exploring Emerging Markets

Outside the US, there are promising opportunities in emerging markets. Countries like Brazil and Mexico offer attractive real yields, with Brazil’s five-year bond yielding 14.1% against an inflation rate of 4.8%, and Mexico’s five-year debt yielding 10.1% against a 4.8% CPI. In contrast, European and Japanese bonds provide little yield above inflation, and Japan even faces the possibility of further interest-rate hikes.

Conclusion

Morningstar’s analysis suggests a strategic shift away from cash towards longer-term bonds and emerging market opportunities. While corporate bonds offer limited returns for their risks, US Treasuries and select global investments present more promising avenues in the current and anticipated economic environment.