Fed Policy Shift Sets Up Move Out of Cash

Even if the Fed doesn’t cut rates, the current pause period is ideal for risk assets.

With eyes on the Federal Reserve’s first meeting of 2024 on Wednesday, and amid wide anticipation the central bank will signal cutting interest rates, investors and financial advisors should be relishing the bullish momentum that typically accompanies dovish turns in monetary policy.

In addition to the way markets traditionally welcome falling interest rates, this cycle will begin with a mountain of approximately $8 trillion in cash sitting in money market funds and expected to seek a new home when yields on cash drop in stride with the Fed’s looser grip.

While some of the idle cash sitting in the relative safety of money market funds, certificates of deposit and other cash equivalents will remain there for a variety of good reasons, market watchers will be justifying putting that money to work in an environment of falling interest rates. 

The good news is there’s no reason to wait for cuts to move out of cash. According to a report from BlackRock, the period between the last rate hike and first rate cut is the best time to invest in stocks and bonds. 

“The best performance comes during the pause period,” said Kristy Akullian, senior iShares investment strategist at BlackRock. 

An analysis of the six-month period before the last rate hike, the six-month period after the first rate cut and the pause period in between showed that both stocks and bonds had their best performance during the pause.

Fed Policy Invites Risk-On Trade 

Looking at Fed monetary policy from February 1995 through November 2023, the BlackRock research shows the S&P 500 Index experienced an average annualized return of more than 21% during the pause periods, while bonds, represented by the Bloomberg U.S. Aggregate Bond Index, had an average annualized gain of nearly 15% during the pause. 

Cash during the pause period had an average annualized gain of 5%, or right about the current high yield for cash. 

During the six-month period after the first rate cut, stocks averaged gains of nearly 15%, bonds averaged nearly 7%, and cash averaged about 4%. 

Only during the period leading to the last rate hike in a cycle did cash outperform bonds, averaging about 4.5%. 

Stocks averaged nearly 7% during that period and bonds averaged less than 3%, underscoring the negative drag of rate hikes on risk assets in general. 

“The performance during the pause period was a little surprising to us, because we expected the rate-cutting environment to be the best for risk assets,” said Akullian.

A few key points to consider when looking at calculations of data over multiple periods is that stock and bond performance is affected by distinct drivers. 

“With equities, it’s more conditional on whether you get a recession or not,” Akullian said. “If you do get a recession (after a period of rising rates) it’s worse in the short term during the pause period but better in the long term.” 

If the economy manages to skirt a recession, which seems likely at this point, the markets will, based on historical precedent, enjoy a relief rally around the end of the hiking cycle and continue to ride on the prospect of rate cuts in the future. 

On the fixed income side, Akullian said, “recession or not, bonds handily outperform cash after the last rate hike.” 

Thus, even with cash and cash equivalents offering yields in the 5% range, investors are usually better off sticking it out in the markets. 

“Part of that is, we’re talking 5% cash yields now, but we don’t expect rates to stay this high for a whole year,” Akullian said. “On the bond side, if you have duration, you can capture yield and price appreciation as well.” 

In some respects, investors moved in the right direction last year, driving a record $200billion worth of net flows into bond ETFs last year, according to Akullian. 

“During the first half of the year it was a lot of money into very short duration ETFs; almost like cash,” she said. “But in the second half, we saw more money going into the intermediate and long duration part of the curve. We still think investors are sitting on more cash than we think is wise given the historical performance we’ve seen during these periods.” 

Contact Jeff Benjamin at [email protected] and find him on X at @BenjiWriter