According to recent economic data, the Federal Reserve may be on the verge of cutting interest rates. This potential shift in policy could significantly impact various investments, with some benefiting more than others. Warren Buffett has compared interest rates to gravity when pricing investments.
From this morning’s @opinion article (link below) on why “The Fed Should Resist Placating Markets.”https://t.co/6feK9zwIXG#economy #markets #FederalReserve #investing #investors #econtwitter pic.twitter.com/eC57EQGN7p
— Mohamed A. El-Erian (@elerianm) August 6, 2024
High rates can weigh heavily on valuations, while low rates encourage growth with little resistance.
On the causes and consequences of the recent bout of market volatility, including why the Federal Reserve should avoid an emergency rate cut.
https://t.co/jpHiwNWAmO#economy #markets @opinion #econtwitter #FederalReserve— Mohamed A. El-Erian (@elerianm) August 6, 2024
However, just as gravity affects the elephant more than the field mouse, changing interest rates impact some investments more than others. If the Federal Reserve does decide to cut rates, three exchange-traded funds (ETFs) stand to benefit significantly.
Current Market expectations for Fed Rate Cuts…
-Sep 18, 2024: 50 bps cut to 4.75-5.00%
-Nov 7, 2024: 25 bps cut to 4.50-4.75%
-Dec 18, 2024: 25 bps cut to 4.25-4.50%
-Jan 25, 2025: 25 bps cut to 4.00-4.25%
-Mar 19, 2025: 25 bps cut to 3.75-4.00%Video: https://t.co/PU3gn1fTbD pic.twitter.com/xuqDaimCyG
— Charlie Bilello (@charliebilello) August 7, 2024
The first is the Hartford Total Return Bond ETF (HTRB), which is actively managed by a team at Wellington and covers a wide range of bond sectors. HTRB favors longer-term bonds than its benchmark and most peers, making it more sensitive to interest rate changes. This means that if rates fall, HTRB could climb higher than other bond funds.
The second ETF is the Vanguard Long-Term Bond ETF (BLV), which is an index strategy that invests heavily in Treasuries. BLV has a longer average duration than most long-term bond funds, making it very sensitive to interest rate changes.
ETFs benefiting from rate cuts
While this can lead to volatility, BLV should excel when rates decline. The third ETF is the Schwab U.S. Small-Cap ETF (SCHA), which provides a well-diversified snapshot of the US small-cap stock market. Small-cap stocks historically respond more dramatically to rate changes than large caps, and if they start to make up ground, SCHA is a solid way to buy in.
The bond market has already been cutting rates, with the 10-year Treasury yield falling to a new low for 2024 at 3.79%. If the Federal Reserve cuts rates by 50 basis points in September, it would be an admission of their failure to cut rates by 25 basis points in July. Fed Chair Jerome Powell has faced criticism for his delayed responses to inflation, and his slow move to address falling inflation has further complicated the situation.
Meanwhile, the Bank of Japan raised their policy rate to 0.25%, leading to a significant appreciation of the yen and potential unwinding of large short positions. Economic data has prompted the Treasury market to cut rates, even though the Federal Open Market Committee did not act in last week’s meeting. The Nikkei 225 Index also saw a steep decline, closely tied to the NASDAQ 100 Index due to leveraged Yen-funded trades.
Geopolitical tensions, such as the recent assassination of a Hamas political leader in Iran, could potentially impact this setup. However, if upcoming CPI reports and jobs data do not offer strong counterpoints to recent trends, the rate cut cycle may not only begin but also involve a sense of urgency.