Rate Cuts Are Coming. Here’s Where to Look for Loftier Yields.

The Federal Reserve, under Chair Jerome Powell, is poised to lower interest rates. That will hurt households but help Uncle Sam by reducing interest costs on the federal debt. (Al Drago/Bloomberg)

You don’t need a weatherman to know which way the wind blows, Bob Dylan famously wrote. So you surely know that the Federal Reserve will lower its interest-rate target at its Sept. 16-17 policy meeting. More relevant are the economic and investment implications of the policy easing.

The cooling of the U.S. labor market ensures that Fed Chair Jerome Powell and his fellow policymakers will accede to the Trump administration’s unprecedented pressure to lower the Federal Open Market Committee’s key federal-funds rate from the current range of 4.25% to 4.50%, which has prevailed since December.

On Friday morning, fed-funds futures placed a 100% certainty on a reduction; the only question is the size of the cut. The odds-on outcome of the two-day confab that concludes on Wednesday is a trim of 25 basis points, or one-quarter percentage point, with a 94.7% probability, according to the CME FedWatch site. The futures market is placing 5.3% odds on a half-percentage-point drop.

The forecasters in the futures market are looking for quarter-point trims at the next two FOMC meetings, in October and December, for a total of 75 basis points of cuts by year end. That’s more than the median guess from FOMC members back at the June meeting, which contemplated two cuts, to a 3.9% midpoint through the end of the year.

Looking further out, futures traders have priced in a total of six quarter-point cuts, to a 2.75%-3% range, by the end of 2026. By contrast, the FOMC members’ median projection was for half as many, to a 3.6% midpoint.

While the market and the solons at the Fed agree that lower short-term rates are in the offing, that will happen even with inflation stubbornly remaining above the monetary authorities’ 2% target. Following sticky readings for August’s producer and consumer price indexes reported this past week, economists estimate that the Fed’s key gauge—the personal consumption expenditures index, excluding food and energy costs—will clock in at a 2.9% year-over-year pace when reported later this month.

As for the Fed’s other policy mandate, maximum employment, the headline jobless rate was 4.3% in August. Not only is that below the 4.5% projected by the FOMC for the end of 2025 and 2026, it is within rounding error of what the panel sees as the long-run equilibrium unemployment rate of 4.5%. What has gotten more attention recently has been the sharp slowing in payroll expansion and negative downward revisions of past tallies.

So, what would the Fed rate cut produce? Lower borrowing costs are elixirs to leveraged borrowers, such as real estate developers. But David Kelly, chief global strategist at J.P. Morgan Asset Management, writes in a research note that a cut in short-term interest rates will reduce income for households by far more than their interest expense. He reckons that a one-percentage-point reduction in short-term rates would lower households’ interest income from money-market investments and such by $140 billion annually.

By contrast, he figures that a similar rate cut might save them only $30 billion, given that their biggest liabilities—home mortgages—are almost all fixed-rate, with most at much lower rates than the current 6%-plus. Housing—the most interest-sensitive sector of the economy—is unlikely to get much of a boost from a drop in the fed-funds rate. (Mortgage rates follow longer-term 10-year Treasury yields, not overnight rates.)

The biggest beneficiary of a lower fed-funds rate is apt to be Uncle Sam. Interest costs have been a major driver of the federal deficit. According to a recent Goldman Sachs research note, the U.S. is headed toward paying more than 4% of gross domestic product as interest by 2029, second only to Italy. Of all Group of 10 nations, the U.S. would benefit the most from a one-percentage-point cut in short-term rates, which would lower its interest cost (as a percentage of GDP) by 0.51 percentage point.

The standard prescription for investors facing lower interest income is to lock in yields before they fall further. But the bond market, not needing a forecaster to tell it where the prevailing winds were blowing, has already priced in Fed rate cuts. On Friday, everything beyond a three-month bill to the seven-year note traded with a “3 handle.”

Even so, veteran fixed-income strategist James Kochan now thinks investors would do better hunkering down and sticking with T-bills, rather than venturing out to lengthier maturities that provide less return for their risk. The so-called belly of the Treasury yield curve trades from 3.58% for a two-year note to 3.83% for seven years, less than 4.04% for a three-month bill. The benchmark 10-year note yielded 4.08% after briefly dipping a hair below 4% on Thursday.

By contrast, TS Lombard strategists Daniel von Ahlen and Andrea Cicione now see more upside risks to U.S. bond yields. And, if you need reminding, when yields rise, bond prices fall.

They write in a client note that 4% will probably be the floor for the benchmark 10-year Treasury. The fed-funds futures market’s expectation of a sub-3% overnight rate by late 2026 is probably too low without a recession, although they concede that effects of pressure from the White House are impossible to forecast.

Conversely, the term premium—the extra yield needed to induce investors to lock up money for an extended period—is likely to increase owing to the administration’s push for Fed cuts and the central bank’s willingness to ease in the face of above-target inflation, they add. Meanwhile, “fiscal concerns are unlikely to dissipate anytime soon, and the recent trends in U.S. governance and institutions continue to be negative for U.S. bonds,” they write.

As a result, U.S. government securities’ attraction as a hedge against risk assets may be lessened; other strategies, notably gold, may serve that role better.

Elsewhere in the fixed-income sphere, corporates provide a near-record-low extra margin of income, both in the high-grade and high-yield sphere. Emerging market bonds offer attractive yields and benefit from the declining dollar.

Municipal bonds also are richly priced, Kochan says. AAA-rated 10-year munis yield only 73% of comparable Treasuries, versus a historical range of 75% to 85%. Selected short-to-intermediate A- and AA-rated munis might be worthwhile on an after-tax basis.

Investors searching for tax-free income might look among perennially neglected closed-end funds. Most are leveraged funds that theoretically ought to benefit from Fed rate cuts. But many have taken the tack of paying more in income than they earn—upward of an 8% purported yield, with the difference coming as a return of capital—to narrow their discounts to net asset value.

Two larger national muni CEFs that have minimal returns of capital are the Pimco Municipal Income II (ticker: PML), and BlackRock Muniyield Quality (MQY), which traded this past week at yields around 6% (worth 7.9% to an investor in a 24% tax bracket). They trade at about a 6% discount to NAV. Both have rallied in anticipation of lower rates. Even in this sleepy corner of the market, they know which way the wind is blowing.

Write to Randall W. Forsyth at randall.forsyth@barrons.com