The Federal Reserve Chairman, Jerome Powell, has given his clearest signal that a rate cut is coming soon. With inflation seemingly on the way down and the US job market starting to soften, there is not much reason for the Fed to keep the interest rate as high as it is now, risking possible recession. So, what can we do to prepare for this coming rate cut?
What The Fed Said?
The Fed Chair, Jerome Powell, said that the ‘time has come’ to cut interest rates. This is one of the most explicit signals the Fed has given that they are ready to pivot soon. The market has also expected a rate cut this September at 100% probability and even more cuts in the following months.
With the interest rate cut possibly coming soon, what can we do to prepare accordingly?
What Are We Doing?
We have been monitoring inflation and US job market data for a while and expect to see rate cuts sometime this year. The market has also been expecting rate cuts this year. As such, we have allocated our assets to try to benefit from this rate reversal.
Locked-In Fixed Income with Higher Interest Rates
If you have been following us, we have advocated locking in these higher rates for as long as possible before they reverse. On our side, we have been migrating our short-term cash allocation from T-bills into Singapore Savings Bonds (SSB) to lock in the rates for up to ten years. SSB allows monthly redemption, which means your money is still relatively liquid, yet you are guaranteed the rates for the next ten years.
That said, a high-interest fixed income is a good and reasonable choice if you seek a short—or medium-term cash investment option, but it may not be preferable if you plan to hold it over the long term.
Positioned into Rate-Sensitive Assets
The higher interest rate generally dampens economic activities. Businesses find it harder to borrow money due to the higher debt repayment they need to service. Certain asset classes underperform the market towards the end of 2022 and 2023. Some examples are businesses with higher debt loads, small-cap companies that are not cash-rich, and REITs.
With interest rates going down, these businesses may be the first to benefit, as their debt servicing costs will start to go down.
Even if we know these high-debt-load businesses may benefit from the interest rate reversal, please remember that we only want to invest in the best companies with solid fundamentals.
Over the past year, we have been adding positions to blue-chip Singapore REITs and Singapore REIT ETFs to prepare for the interest rate reversal. We believe that S-REITs will start to perform well again as interest rates decline. In fact, S-REITs have performed well recently, with interest rate cuts on the horizon.
Positioned into Bonds to Benefit from Price Reversal
Bond price and bond yield have an inverse relationship. If the bond yield goes down, the bond price goes up.
Now that we know the interest rate will likely go down, the implication is that bond yield will also go down, and the bond price will increase. If bond prices will likely increase as the interest rate reverses, why not participate in this appreciation by buying bonds? We previously covered one way to take advantage of this potential bond price appreciation: buying into a long-term bond ETF, such as TLT.
However, please remember that we only consider this as a short-term trade, not a long-term investment.
Continue Investing in the Stock Market
We continue to invest in the stock market regardless of interest rates. We believe the stock market will continue to provide long-term asset appreciation regardless of short-term events such as inflation, interest rates, recession, etc.
To prepare for the upcoming interest rate reversal, we also considered some emerging market equities, which tend to provide more returns when the US interest rate is lower.
Prepare for Possible Recession with Cash on the Sideline
As an analogy, the interest rate is like your car’s gas/brake pedals. When your car is too slow, you can speed it up by pressing the gas pedal. If you want it to slow down, you press the brake pedal. Our economy is like the car, while the interest rate is like the gas/brake pedals. When our economy is overheating, the Fed presses the brake by increasing the interest rate. However, if the Fed presses the brake too long (or interest rates are too high for too long), the car may come to a stop (or a recession in our economy). So, the Fed’s job is to balance the gas/brake to ensure the car is moving steadily.
Now that the Fed is ready to cut interest rates, the question is, will the Fed cut the interest rate at the right pace so that the economy can achieve a soft landing and avoid recession? Well, we don’t know the answer to that question and can only hope there will be no recession.
We have seen several indicators that may point to a possible recession in the future, such as the inverted yield curve and the softening job market. While we hope there is no recession soon, we are always prepared to take advantage of any recession by having some cash on the sideline.
Recession is an excellent opportunity to invest in the best companies in the world at an attractive valuation. That’s something you don’t want to miss, right?
So, are you ready for the future rate cuts? And have you prepared accordingly?
