Where Will Interest Rates Go Next?
At the end of 2023, investors expected the Federal Reserve to cut their target rate six times in 2024. Nearly four months into the year, we’re still waiting for the first cut.
The first chart shows the probability of different Fed Funds target rates at the end of 2024 (click to expand). In December 2023, market watchers were nearly sure the Fed would cut rates this year, and cut pretty aggressively. For reference, their target range at the time was (and still is) 5.25% to 5.50%. This area is shaded light green.
By combining the probabilities for target ranges from 4.00%-4.25% and below, the chance of a rate cut of 1% or less by year’s end was very low, around 1-in 40. There was even a 50% chance rates would be cut by 1.5% this year, all the way to the 3.50% to 3.75% range.
At the same time, the idea of rates remaining high (or even rising) seemed improbable, to say the least. Fast forward to today. As Ron Burgundy might say, that escalated quickly.
The current odds that the lower end of the Fed Funds target range will be 5.0% or higher by the end of the year is basically a 1-to-1 coin flip.
Consider this another example of just how quickly expectations about interest rates can change.
Where are rates going?
An article from the Wall Street Journal last week outlined new forecasts from a variety of different economists.
Source: Wall Street Journal
Changes in interest rates, particularly when unexpected, can have a big impact on asset prices. So it seems perfectly reasonable to want to forecast the direction of interest rates.
Within the article linked above, this chart stood out to me, and provided another reminder that forecasting is hard. We discussed this previously here and here
Three years ago, in July 2021, economists thought the Fed Funds rate would still be below 1% at the beginning of 2024. This is represented by the dotted line at the bottom of the chart. That was before inflation dominated business headlines.
Two years ago, in July 2022, economists expected rates to peak at 3.5% before falling back to under 3.0% by the end of 2024. This is the dotted line in the middle of the chart.
And now, the Federal Funds target range is expected to remain above 3.0% for the next few years. This is the red dotted line.
As we can see, accurately forecasting interest rates is a challenging endeavor, evidenced by the evolving economic predictions, and evolving economic conditions, over the past few years.
Investor reactions
Source: Morningstar Direct
Investors who want to express their views on interest rates can do so in a number of ways. Here is one example, with data from 2021 through today.
Bank loan mutual funds and ETFs tend to benefit from rising rates. And these funds are often treated more like short-term-rentals, not owned for the long-term. Money comes in when rates are expected to rise, and it can leave just as quickly if rates are expected to fall.
From the beginning of 2021 through April 2022, investors plowed more than $57 billion into these funds. And since April 2022 through March of 2024, over $48 billion has been withdrawn.
This chart shows those monthly and cumulative fund flows: green bars show months when money flowed in, orange bars for months when money flowed out, and a black shows cumulative net fund flows during the entire period.
The funds in Morningstar’s Bank Loan category returned an average of 16% from April 2021 through March 2024. Not too bad, considering funds in some of Morningstar’s more rate sensitive bond categories like Intermediate Core Bond lost 10% during the same period.
The timing of flows matters, too. And this part is always easier with the benefit of hindsight. Investors began pulling assets from the category as expectations for rate cuts started to take hold. The dollar-weighted return for the category, which accounts for the timing of flows, was just 2.5% during this period, nearly 14% lower than someone who just bought and held.
Summary
For us, making investments that depend on correctly forecasting the path and timing of short-term interest rate moves seems too hard to consistently get it right. If you are in a similar camp, here are a few alternative ways you can spend your time, and money.
Try to understand the risks in your portfolio. If all your investments tend to be moving in the same direction at the same time, they could be exposed to the same risks. Is that intentional? If not, consider other ways to add diversification.
Have ample liquidity for short-term spending needs. Long-term investments like stocks can make for lousy investments if we are forced to sell to meet short-term goals. Money market funds and other short-term vehicles could provide more peace of mind, while allowed longer-term investments to
Focus on longer-term goals. Forecasting is often a necessary part of investing, and yet I’m convinced making short-term predictions will remain extremely challenging for most people to consistently get right. Having a long-term plan can help investors remain on track.
Interested in talking more?
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