The Rate Environment Is Changing: What to Do Now?

In August, we noted growing consensus that two events were likely to occur: first, a decision by the Federal Reserve to begin lowering short rates, and second, a resulting push on the yield curve that would begin to move it back to its more historically normal, upward-sloping shape.

Both of those events are now underway. The Federal Open Market Committee (FOMC) took an aggressive stance on rate reduction at its September meeting, lowering rates by 50 basis points. The “dot plot” showing projections of FOMC members from the September meeting shows a median projection of a 250 basis point drop by 2026, which would bring rates below the 3.00% mark. The yield curve has begun disinverting between 2-year and 10-year Treasuries and is now positive sloping.

Our August article pointed out a basic conundrum for fixed income investors. If they maintain a short-term posture, they can still reap the benefits of a higher yield than the current market is offering. But when those shorter-term funds must be reinvested, they will likely be at lower rates as the market adjusts to Fed policy. Extending maturity before rates begin to decline significantly can allow investors to lock in higher rates for a longer time, but offsetting lower yields in the short term depends on continuing rate reductions over the long term.

Is now the time to act?

A decision to extend maturity thus depends in part on an assessment of whether the initial downward movement in rates will be sustained. The FOMC members believe so, and the markets are now closer to Fed projections. There are, however, numerous risks on the horizon that could justify a more guarded outlook on future cuts as the Fed tries to manage a “soft landing” that reduces inflation without driving up unemployment.

Significant risks include:

• The elections. Both parties are proposing policies that have the potential to drive up inflation. These include Trump’s proposals to increase tariffs and decrease immigration, and Harris’s proposals to offer credits to first-time homebuyers and increase the child tax credit.
• Job market performance. There will be one more job report—on November 1—before the FOMC’s next announcement on rate decisions, scheduled for November 7. With a strong September job report, the market is moving closer to FOMC projections targeting a total of 50 additional basis points in cuts by the of the year.
• Government shutdown. The current continuing resolution to fund the government will expire on December 20, 2024. If Congress is not able to agree on legislation to extend that deadline, we may face the risk of another government shutdown.
• Geopolitical risk. Tensions continue around conflicts in Ukraine and the Middle East, with indications that the latter may be extending into a broader regional conflict.

Another risk—the longshoremen’s strike that briefly shut down East Coast and Gulf Coast ports—appears to have been averted. It was an indicator, however, of vulnerabilities that can have significant economic impacts.

Other considerations

Because the yield curve below 2-year Treasuries is still inverted, there is no current penalty for maintaining short-term investments. Extending maturity may entail giving up some yield now in the hope of locking in future gains.

Any decision to extend maturity must be weighed against an understanding of the organization’s liquidity needs. Organizations also may also want to reserve some “dry powder” as a buffer against unexpected demands on liquidity or changes in Fed policy assumptions that may slow or stop further rate decreases.

Conclusion

A higher rate environment has presented treasury managers with yield opportunities not available for many years. That environment appears to be beginning to change, but there may be opportunities to extend earning a higher yield by extending maturity. The question is one of timing, and the answer depends on each organization’s assessment of the risks and resource needs that lie ahead.

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