How to Allocate Ahead of Fed Decision

I posed the question because that is how it is often posed to us, but that’s not actually the question I want to try to answer here. Watching from the outside, I’m not that interested in trying to predict exactly what the Fed will do. What does interest me is, given a range of possibilities, how do I want to position my portfolio heading into Jay Powell’s press conference on September 18th?

There seems to be consensus that the Federal Open Market Committee (the Fed) will pursue one of three leading options, with a 25-basis point cut currently the most likely. Where there is less certainty is what exactly they will do (and say), and how to allocate accordingly.

I show the in-depth analysis that I used to try to answer this question and go into more detail on each below, but for now here are the key takeaways:

Effect on Markets: We believe the Fed cutting rates by 25 basis points would “meet expectations” of most investors and our analysis indicates that this move has largely already been priced into the market. Perhaps more important than the rate decision in this scenario is how it is messaged in the press release and press conference. Hawkish language could temper enthusiasm, with market actors treating the cut as if it was less than 25 basis points. On the other hand, more dovish language than expected might lead the market to react as if rates had been eased by more than 25 basis points in September.

Portfolio Adjustments: If you predict a 25-basis point rate cut and think the messaging will be fairly neutral, because it is “expected” and therefore largely priced in, I do not see much benefit to adjusting your portfolio.

Effect on Markets: Our analysis indicates (as would conventional wisdom) that a Fed decision of no rate cut would be an overall negative surprise for the markets broadly (with some exceptions).

Portfolio Adjustments: If you predict no rate cut, the analysis suggests tilting toward the US dollar, energy companies, rate-hedged bonds, and foreign equities domiciled in countries that would benefit from a stronger dollar (generally, countries that are net importers of goods and whose economies do not rely on a lot of debt financing).

Effect on Markets: We believe the Fed cutting rates by 50 basis points would have an overall positive effect on markets broadly (with some exceptions), contrary to the view from some that this could send a negative signal about the economy.

Portfolio Adjustments: If you predict a 50-basis point rate cut, the analysis suggests tilting your portfolio towards potential beneficiaries such as real estate, home builders, long duration bonds, and growth/mid-cap stocks.

If you are looking for some third-party guidance on where the Federal Open Market Committee (FOMC) may settle, CME Group’s FedWatch tool currently forecasts a 100% probability that the Fed will ease rates in September (CME FedWatch – CME Group) based on how Fed Funds futures contracts are trading. They show a 71% probability that the Fed will cut by 25 basis points and a 29% probability that they will cut by 50 basis points (as of September 9, 2024).

Using our Decathlon ETF investment universe as the study group (a global, multi-asset class group of 242 Exchange Traded Funds (ETFs) representing US sectors and sub-sectors, foreign countries and regions, currencies, bonds, commodities and some alternatives), I will look at the interest rate sensitivity of the ETFs as well as how I expect various US Treasury series yields (more detail on the series below) to respond to no cut, a 25 basis point cut, and a 50 basis point cut.

The question I am pursuing is, given a Fed rate cut of X%, how much do I expect each of these bond series to react and, in turn, based on how these bond series react, how do I expect each ETF to react.

An Aside on the Methodology (I am really getting into the weeds here…including showing you the specific equation I used. So, if this level of detail is not for you, click here to skip the math section)

Our PM team internally defines “interest rate sensitivity” as each ETF’s Beta to four different bond  indices – the 13-week treasury (index IVX), the 5-year treasury (index FVX), the 10-year treasury (index TNX), and the 30-year treasury (index TYX). We use the 1-week change for the yield instruments and the 1-week return for the ETFs over the trailing year to compute the betas.

In addition, I computed the sensitivity (or) of these four indices to changes in the federal funds rate. In this case, the 30-trading day percentage change in yield on days when the federal funds rate was adjusted looking over the past 10 years. Thirty days was used as the percentage change window as it roughly aligns to the cadence of FOMC meetings. The reason I used this two-step beta approach, rather than computing the beta of the federal funds rate directly compared to the ETF returns, is the sparseness of changes in the federal funds rate over time. It requires looking back over a much longer period of time, during which the composition of these ETFs may have changed significantly. The two-step approach enables us to capture more recent dynamics of ETF’s sensitivity to interest rates while capturing more stable dynamics of how the various bond series respond to changes in the federal funds rate.

The below chart is a visual of each of the Beta computations I completed for the yield instruments and the 242 ETFs. In total, 972 betas were computed to produce the price impact estimates (4 betas between the change in the fed funds rate and the change in the yield instruments; 968 betas between the four yield instruments and each ETF’s returns).

To compute the estimated price impact for ETF 1, for example, I used the following equation derived from the betas above where the change in the federal funds rate is FF and the estimated price impact is PI:

[(FF * βFVX * βETF1) + (FF * βTNX * βETF1) + (FF * βTYX * βETF1)] / 3 = PI

I removed the 13-Week Beta from the analysis due to it being near zero (see more in the following section). I do not expect these computed price impacts to be specifically predictive, but I do expect them to be directionally correct. This data should be used as a guide for thinking through where to expect the most price impact and in which direction and not as a prediction for what will actually occur. All predictions stated are opinions based on the results of the analysis described.

What is clear from this table is that the highly anticipated 25-basis point cut is mostly already priced in for all four of the current yields, assuming my computed betas are the same as the realized betas when (if?) the FOMC eases the federal funds rate.

Since the 13-Week has so little relation to a change in the federal funds rate (beta at effectively 0), I will ignore that series and from here will focus on the 5-, 10- and 30-year treasuries.

This data should be used as a guide for thinking through where to expect the most price impact and in which direction and not as a prediction for what will actually occur. All predictions stated in this section are opinions based on the results of the analysis (described above).

Let’s start by examining what could happen if the Fed delivers what the market most expects – a 25-basis point cut.

In general, I project little price impact on any of the Decathlon ETFs if the FOMC eases by 25 basis points. The ETFs in the Decathlon universe would on average experience a +0.15% price impact. There are a handful of ETFs that project to have slightly larger gains and losses as a result, but those are still less than +/- 1%.

The outliers on the positive side are China region ETFs, foreign currencies, and real estate. The outliers on the negative side are the US dollar, a handful of country-specific equities (notably Argentina, Switzerland and Vietnam), municipal bonds, rate-hedged bonds, and somewhat more interestingly, the cybersecurity sector.

If the FOMC were to opt not to cut rates, there appear to be significant potential impacts (assuming the drop in yields for the 5-year, 10-year and 30-year treasuries that we’ve seen from the end of July were to completely reverse on the news).

On average, ETFs in the universe would experience an anticipated -0.75% price impact, about 4 times the magnitude of the projected price impact for a 25-basis point cut. Seventy-nine ETFs (about 1/3 of the universe) would have a projected loss of 1% or more.

In general, China region stocks, growth-oriented and small/mid cap US equities, long duration fixed income, foreign currencies, real estate, and other rate-sensitive sectors would be the most negatively impacted if the FOMC were to hold rates steady in September. In addition, sectors that benefit from M&A activity like biotech and smaller cap technology also project to be negatively impacted by a continued pause in rates.

There are a few countries that would experience the most positive impacts with no rate cut (Argentina, Vietnam, Netherlands and Switzerland), as well as the cybersecurity sector, the US dollar, energy businesses, and some select bond instruments (municipal bonds, foreign treasuries, and rate-hedged bonds most prominently).

Finally, what could happen if there is a positive surprise of a 50-basis point rate cut? (I would consider this a positive, though some commentators apparently wouldn’t.)

A positive surprise by my model would produce the most dramatic impact on security prices on the gains side of the spectrum. It would be a significant positive for most ETFs in the universe, producing an average +1.65% change in prices. Seventy percent of the ETFs in the universe would have an anticipated gain greater than 1% and 87% would have some net gain.

In this case, the types of securities most negatively impacted by a 50-basis point cut are those that would have benefited most from no cut; the opposite is also true—those most positively impacted by a 50-basis point cut are those that would be most negatively impacted by no rate cut.

In summary, here are discrete ways to adjust your allocation based on your own prediction of both what the FOMC will do as well as how they will message their action:

If you predict a 25-basis point rate cute:

If you believe the most likely case for September is for the FOMC to do what the market expects, it appears there is little action to take to proactively manage your portfolio ahead of the September 18th decision announcement and press conference. Most of the impact appears to be priced in.

If you predict no rate cut:

If you believe the FOMC are more likely to not cut at all than ease beyond the expected 25 basis points, you may want to tilt toward the US dollar, energy companies, rate-hedged bonds, and countries that would benefit from a stronger dollar.

If you predict a 50-basis point rate cut:

If you have the opposite view, that the FOMC may cut more aggressively than anticipated, you may want to tilt your portfolio towards potential beneficiaries such as real estate, home builders, long duration bonds, and growth/mid-cap stocks.

The real question becomes, then, what is Jay Powell likely to signal in the press conference? Does he indicate a more dovish target than the market anticipates, or does he temper the cut with more hawkish language? Because the market is anticipatory, securities could move as if the 50-basis point cut had occurred (or as if the rate was held flat) just based on how aggressive Powell is in messaging the committee’s future policy trajectory.

We are watching our Decathlon models closely to make sure we understand the rate sensitivity of any ETFs we are considering for purchase or sale ahead of the FOMC meeting.

Decathlon is a suite of global asset allocation strategies that seek to make marginal asset allocation decisions for clients as market dynamics change, so they don’t have to. While our strategies are built on a machine learning-based system, the portfolio managers apply their multidisciplinary experience and real-world investment expertise to conduct ongoing research like I’ve described here. Learn more about Decathlon here.

Good luck out there!

For more news, information, and analysis, visit the ETF Strategist Channel.

Disclosures:

Copyright © 2024 Beaumont Capital Management LLC. All rights reserved.

Certain information contained herein constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events, results or actual performance may differ materially from those reflected or contemplated in such forward-looking statements. Nothing contained herein may be relied upon as a guarantee, promise, assurance or a representation as to the future.

This material is provided for informational purposes only and does not in any sense constitute a solicitation or offer for the purchase or sale of a specific security or other investment options, nor does it constitute investment advice for any person. The material may contain forward or backward-looking statements regarding intent, beliefs regarding current or past expectations. The views expressed are also subject to change based on market and other conditions. The information presented in this report is based on data obtained from third party sources. Although it is believed to be accurate, no representation or warranty is made as to its accuracy or completeness.

The charts and infographics contained in this blog are typically based on data obtained from third parties and are believed to be accurate. The commentary included is the opinion of the author and subject to change at any time. Any reference to specific securities or investments are for illustrative purposes only and are not intended as investment advice nor are they a recommendation to take any action. Individual securities mentioned may be held in client accounts. All benchmarks and indices used are for illustrative purposes only. Past performance is no guarantee of future results.

As with all investments, there are associated inherent risks including loss of principal. Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Sector and factor investments concentrate in a particular industry or investment attribute, and the investments’ performance could depend heavily on the performance of that industry or attribute and be more volatile than the performance of less concentrated investment options and the market as a whole. Securities of companies with smaller market capitalizations tend to be more volatile and less liquid than larger company stocks. Foreign markets, particularly emerging markets, can be more volatile than U.S. markets due to increased political, regulatory, social or economic uncertainties. Fixed Income investments have exposure to credit, interest rate, market, and inflation risk.  Diversification does not ensure a profit or guarantee against a loss.

Beta is a measure of how an investment’s returns change in relation to the market. It’s a way to quantify the risk or volatility of an investment compared to the market as a whole.

Treasury yields are the interest rates that the U.S. government pays to borrow money for varying periods of time.

The federal funds rate is the interest rate at which banks lend money to each other overnight. It’s also known as the federal funds target rate. The 13-week US Treasury bill index is the highest accepted discount rate from the most recent 13-week Treasury bill auction. The 5 Year Treasury Yield Index (FVX) is an index that represents the average yield of a range of Treasury securities that have been adjusted to a five-year maturity. The 10 Year Treasury Yield index, with the ticker symbol TNX, is a reference point for the average yield of a range of Treasury securities adjusted to a 10-year maturity. The 30 Year Treasury Yield index, also known as TYX, is a yield index that tracks the yield of 30-year Treasury bonds.

Beaumont Capital Management (BCM) strategies invest solely in ETFs. No Beaumont Capital Management (BCM) strategy holds a direct position in the stock of any company mentioned in this article. However, BCM strategies may currently hold ETFs that have positions in the companies mentioned in this article.

Beaumont Capital Management LLC

125 Newbury St. 4th Floor, Boston, MA 02116 (844-401-7699)