We asked Teresa Ho, Head of US Short Duration Strategy at JPMorgan, and Robert Motroni, Portfolio Manager, J.P. Morgan Asset Management, to walk us through the Federal Reserve (Fed)’s decision to cut interest rates in September, what they think the central bank might do next and how it all impacts short-term bonds and money market funds.
The Fed cut interest rates by 25 basis points (bps) at the September meeting, bringing the target Fed Funds range to 4.00 – 4.25%. What were the key factors behind that decision?
TH: The labor market drove the Fed to cut rate at the September meeting. The jobs market has been steadily cooling over the last few months, as reflected in both monthly payrolls and weekly claims data. Unemployment was 4.0% at beginning of year and has risen to 4.3%. Fed Chair Jerome Powell called this a risk management cut due to the softening labor market.
At the same time, it’s also important to note that the softening in the labor market is due to less hiring activity vs. an increase in layoffs. The economy has been relatively resilient: growth has not rolled over and retail sales, which contribute two-thirds of GDP, remain fairly strong. In fact, we have consistently revised our GDP forecast higher. The potential for inflation to increase is also still a concern. These are some of the reasons the Fed did not cut more aggressively at the September meeting.
The Federal Open Market Committee’s next meeting is on October 28th, followed by a meeting on December 8th. Where do you see the Fed going from here?
TH: Our house view is more cuts are coming. We would need to see a big reversal in the labor market for the Fed not to cut again and that’s not our forecast. We are anticipating unemployment to increase to 4.5% by the end of year. As a result, we expect the Fed to cut interest rates 25 bps in both October and December and then again in January. That would be 100 bps of easing resulting in a target Fed funds rate of 3.25% – 3.50%. In line with our expectations, markets are pricing around 88% chance of two more cuts this year.
RM: Our trading desk is actually divided over whether the Fed will cut one or two more times this year. I am generally leaning towards two cuts for the same reasons as Teresa.
Also, historically, when the Fed starts cutting rates, successive cuts often follow. This pattern increases the potential of another rate cut in October, even as the Fed remains data dependent.
What is the Fed monitoring most closely as we head into year end?
TH: In addition to monitoring the labor market, the Fed wants to see if recent price increases are sustained because it does not want to have to cut rates and then raises rates again soon. It’s possible that inflation could still strengthen as the impact of tariffs may not be fully coming through yet.
If inflation is persistent—or worse, it accelerates—and growth stays strong, the Fed could hike again. However, if tariffs are impacting growth via labor market weakness, the Fed might could cut rates instead. At this point, we think the likelihood of a hike is low and the bar to hike is high.
Outside of inflation, financial conditions have been resilient. Equity markets are at all-time highs and credit spreads at all-time tights. The Fed will be watching closely for signs of an asset bubble forming.
The Fed has a dual mandate of price stability and maximum employment. However, there’s recently been a lot of discussion around the Fed’s role in a third mandate—pursuit of moderate long-term interest rates—and Fed independence. How are you looking at these concepts?
TH: Moderate long-term rates mean trying to keep long-term borrowing costs at a reasonable level—not too high to stifle growth yet not too low to fuel bubbles. In general, the Fed achieves this by focusing on its dual mandate, so it has not actively sought to control long-term interest rates.
Recent market volatility has brought this third goal into sharper focus. The U.S. government intends to spend more in the coming decade, which translates into higher Treasury term premiums that get baked into risk-free rates and increase yields. Increasing attention on Fed independence could also increase yields if markets start to price in a Fed that is more accommodative than it needs to be, fueling inflation and growth to the point that it might have to raise rates. This will steepen the Treasury yield curve and increase borrowing costs.
A lot of asset prices look to the Treasury curve in terms of where things get priced so there could be broader implications.
How is J.P. Morgan positioning its Money Market Funds in anticipation of more rate-cuts?
RM: Facing a declining rate environment, we’re positioning the funds for additional rate cuts by increasing duration. This is reflected in in the weighted average maturity (WAM) of the portfolio, which shareholders can monitor daily.
With the expectation of interest rates cuts, WAMs in the portfolio have pushed higher into the mid 40s to upper 50s; this is relatively high, given that money market fund WAMs are not allowed to exceed 60 days. However, keeping an eye on WAM is just one piece of the puzzle for shareholders. There are several ways a fund can arrive at a WAM in the mid-40s to upper-50s, so it’s important to understand the maturity structure and have regular conversations with the portfolio managers. This helps to ensure the fund is positioned for optimal performance—not just at the start of the cycle, but throughout its duration.
Can you expand on that and talk about how your team makes those decisions?
RM: As money market portfolio managers, our primary objectives are the preservation of principal and liquidity – with the third goal of performance being tertiary in nature. After we’ve satisfied our first two goals, we can then look to performance.
As investors in the short end of the curve, we are highly focused on the Fed’s actions. We first build out our expectations for the Fed and determine our breakeven curve, which is essentially where we think overnight rates will be, on average, over time. We then weigh investments against this curve and if they have a higher yield we may add them to the portfolio.
But we also consider other factors. The level of supply in the market is one example. For instance, after the debt limit was increased, we expected Treasury supply to increase, which could push yields higher. So we had to decide if we wanted to add Treasuries then or wait to add when the supply hit the market. We also look at the relative value of potential trades to Treasuries and if we are being compensated for the additional risk associated with those trades.
Our industry is also highly regulated with rules around which issuers we can purchase, in what quantity and in what duration. Only after considering all these factors and others in a matrix approach can we then begin constructing the portfolio.
Where do you see the money market fund industry going over the next 12 months?
TH: Uncertainty around interest rates and high valuations in other assets will likely drive money market assets under management (AUM) higher. At the start of the year money market funds had $7.1 trillion AUM and that’s grown to $7.5 trillion. Even with the potential for interest rates to come down in the near term, a terminal rate of over 3% still looks attractive to many investors.
RM: Agreed. Rates still look attractive and general macroeconomic uncertainty may continue to push investors toward money market funds. There are also some cyclical factors at work, and we usually see more flows in the second half of the year.