The Fed has started cutting interest rates. Now what?

Key takeaways:

• Cash yields are projected to drop, potentially forcing income investors to get more creative in driving risk-aware income.
• Stocks, bonds and alternatives have each outperformed cash following previous Fed rate cuts.
• Dividend equities, higher yielding bonds, and options overlay strategies can all help drive higher yields for income-seeking investors.

The moment we’ve spent over a year waiting for has arrived: the Federal Reserve has officially cut interest rates for the first time since March 2020.

The impact of a Fed rate cut on money market funds and bonds

With $6.1T still sitting in money market funds and an additional $350B invested in ultra-short bond funds, many investors are likely starting to plan for the next phase of their income portfolios. After all, the one certainty we have around Fed rate cuts is that, when the Fed cuts interest rates, cash yields come down.¹

When the Fed starts cutting rates, yields fall… particularly in shorter-dated bonds
Average 12m yield change following the first rate cut, 1981-2020

The good news? Most assets have historically done well when the Fed starts cutting interest rates. As is frequently the case, staying invested may be the most important decision that you can make.

Stocks, bonds and alternatives have historically done well when the Fed starts cutting
12M performance following the first Fed cut

But with markets forecasting 250 bps in rate cuts by the end of 2025,² those who have gotten used to 5%+ yields with little-to-no risk may need to get more creative with their income portfolios.

Building an income portfolio when rates are falling

Alex Shingler and Justin Christofel, BlackRock’s co-heads of income investing for our multi-asset strategies group, manage a suite of multi-asset income models and portfolios for BlackRock. I asked them for their thoughts around positioning income portfolios in this environment:

What matters is “Why?”

When thinking about how to position portfolios during a cutting cycle, it’s more important to consider why the Fed is acting than the precise size and timing of rate cuts. Are they cutting rates because of positive signs like steady disinflation? Or are they cutting due to negative factors like a feared sharp drop in economic growth and job losses?

The economic backdrop matters a lot: in past cutting cycles, the 10Y treasury rate has dropped meaningfully following the first Fed rate cut… if the economy also tips into recession. When the Fed cuts in a “no recession” scenario, however, the 10Y treasury rate stayed roughly flat.

The longer-term interest rate outlook depends on whether or not we see a recession
Average of 10Y treasury yields before and after the first Fed rate cut

We believe we’re in for “no recession” rate cuts

The recent rise in the unemployment rate has stirred up recession fears among investors because, historically, the two go together. This time, so far, is different. The U.S. is emerging from one of the hottest labor markets in history, so even though the unemployment rate is going up, it hasn't exceeded normal mid-cycle levels. More importantly, we’re not seeing a large increase in job losses. Nearly half of the increase in the unemployment rate is due to new job seekers, and unemployment filings are nowhere near the levels we’ve seen in prior episodes.

We may be headed for a ‘no hire, no fire’ economy, but our base case is that the U.S. is not on the brink of a recession, and that this will be a ‘good news’ cutting cycle.

How to trade a ‘good news’ cutting cycle?

There’s no easy formula that always applies to cutting cycles, but here are a few things we’re doing in our portfolios and models:

• Staying overweight equities – and dividend-paying equities in particular – with a supportive Fed and our optimistic growth outlook.
• Using covered calls to take advantage of volatility and generate additional income.
• Keeping some floating rate bond holdings, such as AAA-rated CLOs, since our “no recession” expectation may result in fewer cuts than are priced into markets.
• Avoiding duration at the long end of the curve, where there is risk from increased government spending and limited exposure to Fed rate cuts, and instead getting our duration from intermediate-term bonds.
• We’ve also sold out of U.S. preferreds, which look rich and especially prone to drawdowns in a sell-off.

Getting your income portfolios ready for falling cash rates

The average advisor equity and fixed income sleeves are currently under-yielding cash, leaving plenty of space to add to higher-yielding asset classes.

Income opportunities in multiple asset classes
Yields

Performance data quoted represents past performance and is no guarantee of future results. Investment returns and principal values may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. All returns assume reinvestment of dividends and capital gains. Current performance may be lower or higher than that shown. Refer to blackrock.com for most recent month-end performance.

While the era of high cash rates may be winding down, we still see plenty of opportunity to generate income in a risk-aware way: high quality dividend payers, options overlay strategies, and plus sector bonds, just to name a few.

BlackRock can help you construct well-diversified portfolios designed for today’s markets. Contact your BlackRock representative for more information or explore our online investment tools and resources.

Explore the Multi-Asset Income models for more details on how Alex and Justin are thinking about generating income in today’s environment and also the Advisor Outlook – BlackRock’s monthly market outlook for financial advisors – for more details on our latest market and portfolio insights.

Multi-Asset Income Models Advisor Outlook

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