The case for bonds over cash as Fed slows rate hikes
Catherine Magyera
Senior Investment Product Manager
Joe Dowd
Product Manager
KEY TAKEAWAYS
  • Bonds have historically benefited as the Federal Reserve (“Fed”) ended its federal funds rate hiking cycle, with the best returns coming in the months immediately following the last Fed hike. 
  • Investors who waited for the Fed to cut missed a good portion of results.
  • Investors should consider redeploying cash into bonds as the Fed moves towards pausing hikes and eventually considers cuts.

Bonds have benefited as the Fed neared the end of rate hikes


Investors who wait to add fixed income to their portfolio may miss out on an opportunity to benefit as the Fed’s rate-raising cycle ends. Historically, the most profound benefit occurred in the months immediately after the last Fed hike of the cycle. These opportunities tended to coincide with the end of an economic cycle, when slowing growth and possible recession lead central banks to loosen monetary policy.


The chart above is titled, “Bond fund returns have been front-loaded as the last four Fed cycles transitioned.” The line graph in the chart above shows how bond fund returns have been front-loaded as the last four Fed cycles transitioned. Returns are illustrated on the Y axis between 0% and 12%. Months since last Fed hike is illustrated on the X axis, with 1, 12, 24 and 36 months displayed. The image illustrates the results for Intermediate Core-Plus Bond, Intermediate Core Bond, Muni National Long, Muni National Intermediate and Short-Term Bond sectors after the final Fed rate hike. The chart call-out is titled, “Maximum return after the final hike was delivered within 11-12 months in all sectors.”

Sources: Capital Group, Morningstar. Chart represents the average returns across fixed income sectors using respective Morningstar categories in a forward extending window starting in the month of the last Fed hike in the last four transition cycles from 1995 to 2018 with data through 3/31/2023. Results less than one year are cumulative and annualized after one year. Past results are not predictive of results in future periods.

Why waiting to invest in bonds may have led to disappointment


In the previous four transitions from the last Fed rate hike to a rate cut, bond sectors including: core, core-plus, short-term and municipals (“munis”) posted positive returns. In the first year after the last Fed hike, returns ranged from 4% to 12% on average. These bond sectors continued to gain as the Fed lowered rates.


The average time between the last Fed hike and first rate cut has been 10 months in the prior four hiking cycles. Given this, investors waiting for the Fed’s first rate cut may be missing a chance to benefit from a potential initial upswing. While it may be tempting to try to time the market, history shows that having gotten it wrong might have been a costly mistake.


Yields often peaked slightly before the last Fed hike


The past four Fed hiking cycles also show yields often peaked prior to the last Fed hike of the cycle. The chart below shows the yield on the 2-year U.S. Treasury peaked, on average, a month before the final hike. This suggests that trying to time the last Fed hike as an entry point may have limited benefit as yields may have already begun to fall at that point and price gains have occurred.


The chart above is titled, “Historically, yields often peaked prior to the final Fed cycle hikes.” The chart call-out is titled, “In prior cycles, the first rate cut occurred at least 7 months after the final hike.” The line graph in the chart above shows four periods of Fed hiking cycles and how historically yields peaked prior to the final Fed cycle hikes. Two-year Treasury yields are illustrated on the Y axis, between 0% and 8%. Months since last rate hike is illustrated on the X axis, between -6 and 18 months. A diamond represents the peak yield for each of the cycles listed. A triangle represents the first rate cut for each of the cycles, not including the current cycle. For the Tech bust, the starting yield was 5.9%, the yield peak was 6.9% on 5/12/2000 and the first rate cut was 1/3/2001, 8 months after the peak. For the Housing bubble, the starting yield was 4.4%, the yield peak was 5.3% on 6/23/2006, and the first rate cut was 9/18/2007, 15 months after the peak. For the Energy crisis, the starting yield was 2.5%, the yield peak was 2.9% on 11/9/2018 and the first cut was 8/1/2019, 7 months after the peak. For the Current period, the starting yield was 4.7% and the peak yield was 4.9% on 3/3/2023.

Sources: Capital Group, Bloomberg. As of 5/4/23. For the following periods, the last Fed hike dates were: Tech bust (5/16/00), Housing bubble (6/29/06), Energy crisis (12/20/18) and Current (5/4/23). Past results are not predictive of results in future periods.

Bottom line: Consider allocating to bonds over cash


As the Fed considers pausing and eventually cutting rates, moving to a normalized rate environment, it will be important for investors to think about returning to a more balanced, long-term asset allocation. We believe trying to time interest rates is difficult and the Fed is near the end of its hiking cycle. Investors should determine if they might be better served by allocating to bond funds, rather than holding onto cash.


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Published on May 31, 2023

Catherine Magyera is a senior investment product manager with 17 years of industry experience (as of 12/31/2023). She holds a bachelor's degree in history from University of Pennsylvania. 

Joseph B. Dowd is a product manager with 14 years of industry experience (as of 12/31/2023).  He holds an MBA from the Marshall School of Business at the University of Southern California and a bachelor's degree in political science from University of California, Riverside.

Additional perspectives

Investments are not FDIC-insured, nor are they deposits of or guaranteed by a bank or any other entity, so they may lose value.

The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight.

Past results are not predictive of results in future periods.

Income from municipal bonds may be subject to state or local income taxes and/or the federal alternative minimum tax. Certain other income, as well as capital gain distributions, may be taxable.