Navigating interest rate cycles: cash versus bonds
19 Jun, 2024

 

Paul Hutchinson, Sales Manager, Ninety One

 

In the wake of the fastest interest rate hiking cycle in decades, there is a growing consensus that global rates have broadly peaked. However, sticky inflation, off the back of a more resilient US economy, suggests that interest rates will now remain higher for longer, with the first rate cut now only expected towards the end of 2024. This contrasts materially with the view held towards the end of last year, where the market was predicting six or seven 25 basis point rate cuts each by the US Federal Reserve (the Fed) in 2024.

 

So, while money parked in bank accounts or money market unit trust funds will continue to earn an optically attractive interest rate, it is not the optimal investment for a conservative investor.

 

Figure 1: The path of the US Federal Funds Rate

Source: Bloomberg

 

An analysis of post-hike periods in the US since 1990 reveals interesting insights. Before announcing the first rate cut, the Fed typically paused (held rates unchanged) for an average of 10 months. What is more interesting, however, is the relative performance of US cash (as represented by the Bloomberg US 1-3 months Total Return Index) and bonds (as represented by the Bloomberg US Aggregate Bond Index) in the period immediately preceding the final hike, the period during which rates were kept on hold, and then the period immediately following the first rate cut.

 

Figure 2: The average performance of US cash and bonds at various times in the interest rate cycle

Source: iShares, reproduced by Ninety One

 

US cash outperforms US bonds in the 6 months leading up to the last hike; this being the case as the bond market continues to price in the possibility of further hikes (the peak of the rate-hiking cycle is only ever known after the event), and therefore the income earned on cash exceeds the income and capital return from bonds during this period.

 

It is then in the rate-pause period, and the period following the first rate cut, when the bond market starts to price in interest rate cuts, that investors earn more from the capital move in bonds than they earn from simply earning the income on cash.

 

However, while everyone expects bonds to outperform cash materially in a rate-cutting cycle, what is particularly interesting is the magnitude of the outperformance by bonds over cash in the rate-pause period, as shown in the chart above. This picture is also evident in the South African context.

 

The key insight from the above is that investors should avoid sitting on the sidelines in cash, as historically a rate-pause period has been good for fixed income funds relative to money market funds, as has the subsequent rate-cutting period. Conservative local investors should consider a diversified income fund, such as the Ninety One Diversified Income Fund. This actively managed, well diversified flexible fixed income fund looks to participate when the South African bond market outperforms cash which, given the above, we expect to be the case as we proceed through the rate pause into the rate-cutting environment.

 

ENDS

Author

@Paul Hutchinson, Ninety One
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