Financial advisors torn between trusting the Fed and trusting the bond market

With the Fed’s most recent interest-rate hike less than a week old, the bond market is already bracing for a reversed course that could see rate cuts as early as June, reflecting the lingering concerns about the global banking system.

“Every single indicator points to rate cuts, which flies in the face of what the Fed is saying,” said Sumit Roy, senior ETF analyst at ETF.com.

Roy, who said the bond market is anticipating a full percentage point reduction in the Fed’s rate by year-end, cited flows into Treasury bond ETFs and pressure on Treasury yields as evidence of what the bond market is expecting in terms of rates.

The iShares 20+ Year Treasury Bond ETF (TLT) and the iShares 7-10 Year Treasury Bond ETF (IEF) rank as the fourth and fifth most popular ETFs this year, taking in $4.5 billion and $4.7 billion, respectively. At the same time, the yield on the two-year Treasury bond has dropped to 3.9%, down from 5% two weeks ago.

“If the market thought rates were staying at 5% for any period, you’d expect the two-year Treasury to be closer to the Fed rate, but it’s significantly lower,” Roy said.

For financial advisors who spent much of the past two years guiding clients through runaway inflation and an aggressive string of rate hikes, the balancing act is about to get even more challenging.

Nicholas Bunio, a financial planner at Retirement Wealth Advisors, said he's already started preparing clients for the next phase of the Fed’s monetary policy.

“I have told my clients I am investing very slowly, over six or seven months, as we don't know how things will be in the future,” he said. “Plus, there is the debt ceiling that is a looming issue.”

Bunio said it’s too soon to bet on a rate cut even though he's anticipating an economic slowdown.

“The Fed said that one more rate hike is coming, but after that we don't know,” he said. “I think that's a good sign that, maybe rates won't be lowered this year, but a pause and panic will push rates down anyway, and that could be a good opportunity to put extra cash to work.”

The bond market, meanwhile, isn’t buying what Federal Reserve Chair Jerome Powell was selling during his post-hike press conference last week. ETF.com's Roy said the Fed’s policy reversal could kill two birds with one stone.

“People are thinking the Fed has to react to the banking crisis and cut rates,” he said. “And the banking crisis will also help the Fed do its job and cut inflation, because the banks will have to cut back on lending to try and shore up their balance sheets.”

Paul Schatz, president of Heritage Capital, sees the bond market responding but still isn’t convinced it's accurately forecasting the Fed’s next move.

“While I have been a strong critic of the Fed and thought they should have hiked years ago, I also think they are wrong now and are hiking too far,” he said. “They should have been neutral. I don’t advocate for rate cuts in the next quarter or two.”

Kashif Ahmed, president of American Private Wealth, also isn't convinced the Fed would reverse course so quickly.

“I don't think the government will cut rates any time soon, and it should not,” he said. “Some of the excesses still need to be flushed out of the system.”

Joel Mittelman, president and chief investment officer at Mittelman Wealth Management, is taking what the market is giving him and not making any assumptions about what the Fed might do next.

“It’s never too soon to start preparing for a perceived change in investment crosswinds,” he said.

In preparation for peaking interest rates, Mittelman has a three-pronged approach that starts with transitioning out of cash to build bond ladders with individual Treasury bonds and municipal bonds.

Step two involves rebalancing portfolios to get clients back up to their risk targets. And finally, Mittelman is preparing clients for continued volatility.