Bonds vs. Stocks: Why Bonds Can Outperform in a Rate Cut Environment

1. Sensitivity to Interest Rate Cuts: As rates decline, bonds, particularly longer-duration bonds, are more sensitive to these changes, benefiting from the increase in bond prices.
2. Stable Income: Bonds provide regular interest payments, which become more valuable as interest rates fall and alternatives like savings accounts offer lower returns.
3. Risk Management: In times of economic uncertainty, bonds tend to be less volatile than stocks, providing a cushion for investors who prioritize capital preservation.
​4. Portfolio Diversification: For investors concerned about stock market volatility or an impending recession, bonds can serve as a valuable diversification tool, lowering the overall risk of a portfolio.

Challenges to Bond Outperformance

While bonds offer compelling advantages in a falling-rate environment, there are risks to consider. If inflation rebounds or economic growth is stronger than expected, the Federal Reserve may not cut rates as deeply as anticipated. In such cases, bond prices could decline as yields rise, impacting returns. Furthermore, a sharp recovery in the stock market could divert attention from bonds back to equities, reducing the momentum in bond markets.

Understanding the Relationship Between Yield Curve, Money Supply, and Economic Policy
The current state of the U.S. bond market, interest rate expectations, and central bank actions highlight the intricate relationship between short and long-term bonds, the yield curve, money supply (M1, M2, M3), and broader economic activity. As we head into the September FOMC meeting, there’s speculation about a 50 basis point (bps) rate cut, and it is essential to understand how such cuts impact various economic levers, including the velocity of money, lending markets, and the U.S. debt situation.

The Yield Curve: Short vs. Long-Term Bonds
When the yield curve steepens or un-inverts, it reflects a narrowing gap between short-term and long-term bond yields. Currently, shorter-term bonds like the 2-year U.S. Treasury bond offer higher yields than long-term bonds like the 20-year bond. This inversion exists because of the Federal Reserve’s high interest rate policy, with the 2-year yield reflecting higher short-term borrowing costs.

However, market expectations—often informed by forward-looking guidance from the Federal Reserve, such as the “dot plot”—suggest that these high rates won’t persist indefinitely. The longer-term bond yields, therefore, remain lower as they factor in the expectation that rates will eventually fall. The sensitivity or “rate of change” of long-duration bonds to interest rate cuts or hikes is greater than that of short-duration bonds, which is why we observe the shape of the yield curve.

How a 50 Basis Point Cut Will Impact the Yield Curve
A 50 bps rate cut, particularly at the September FOMC meeting, would directly lower the yield on short-term bonds, such as 2-year Treasuries, bringing their yields closer to those of long-term bonds. Since longer-term bonds like 20-year Treasuries are more sensitive to interest rate changes, their yields might decline further as well. This is because rate cuts reduce the cost of borrowing over the long term, pushing bond prices up and yields down.

This steepening of the yield curve could signal a shift in investor sentiment, from expecting short-term economic slowdowns to anticipating longer-term growth. Historically, however, such significant rate cuts often precede a recession. A 50 bps cut, especially early in a rate-cutting cycle, tends to coincide with fears of a slowing economy, as central banks typically lower rates to stimulate demand when economic conditions worsen.

Impact on Money Supply: M1, M2, and M3
The money supply, measured through M1 (liquid assets like cash), M2 (M1 plus near-money), and M3 (M2 plus larger liquid assets), is influenced by interest rate changes. A 50 bps rate cut will likely stimulate an increase in the money supply as borrowing becomes cheaper and liquidity increases in the system.

Lower interest rates reduce the incentive to save and encourage spending, thereby increasing the velocity of money (the rate at which money changes hands). This can lead to an expansion of M1 and M2, particularly if lending grows. However, this expansion can also affect inflation expectations, which is why central banks balance rate cuts cautiously.

Reverse Repo, Treasury General Account, and Credit Lending Facilities
The reverse repo (RRP) market, where financial institutions lend money to the Federal Reserve overnight in exchange for Treasury securities, plays a vital role in controlling liquidity. A rate cut can lead to lower returns in the RRP market, making it less attractive for banks to park excess reserves. Instead, these funds may flow back into the economy through lending, contributing to an increase in the money supply and potentially stimulating credit markets.

Simultaneously, the Treasury General Account (TGA)—essentially the government’s checking account at the Fed—can affect liquidity. If the Treasury draws down its account for spending (such as fiscal stimulus), this injects liquidity into the economy, further stimulating activity.

A rate cut will also influence credit lending facilities, impacting car loans, mortgages, and credit cards. Lower rates make borrowing cheaper, which can boost consumer spending and economic activity. Mortgage rates, in particular, are sensitive to changes in longer-term bond yields. As these yields decline in response to rate cuts, mortgage rates may fall, making homeownership more affordable and potentially boosting the housing market.

The U.S. Debt and Inflation
The U.S. debt, currently over $33 trillion, remains a critical issue for policymakers. Inflation is one tool the government can use to “inflate away” debt. With lower real interest rates, the burden of debt diminishes in real terms as the value of money erodes over time. A 50 bps rate cut would lower the cost of servicing this debt, while higher inflation—within moderate bounds—can reduce the debt’s real value.

However, this strategy has its risks. Excessive rate cuts, if they overstimulate the economy, can lead to runaway inflation, undermining the very stability central banks aim to maintain. The Fed must walk a fine line between stimulating growth and managing inflation expectations.

Historical Precedent: Rate Cuts and Recessions
Historically, the first rate cuts in a series, especially a significant one like a 50 bps cut, often coincide with recessionary periods. For example, the Fed cut rates by 50 bps in 2001 and 2007, both of which were followed by recessions. Rate cuts are usually a response to weakening economic indicators, as they are intended to support growth by lowering the cost of borrowing. However, these cuts also signal that the central bank is concerned about the future outlook, which is why they often precede downturns.

Conclusion

The current financial landscape, with an inverted yield curve and expectations of a 50 bps rate cut in September, underscores the delicate balance central banks must strike. While such a cut will ease borrowing costs and potentially steepen the yield curve, it also raises questions about the long-term economic outlook. The interplay between bond markets, money supply, and central bank actions will determine the future trajectory of the U.S. economy, with potential impacts on everything from consumer credit to mortgage rates.

​The need to manage the U.S. debt burden through inflationary pressures and low interest rates adds another layer of complexity, highlighting the broader economic implications of rate cuts and their potential to signal forthcoming recessions.

With the Federal Reserve signaling further rate cuts and the bond market seeing record inflows, bonds are well-positioned to outperform stocks in the near term. The surge in bond-focused ETFs, particularly actively managed funds, reflects the growing interest in fixed income as investors seek to lock in higher yields and mitigate risk in a volatile economic environment. As bonds benefit from lower rates, they provide a compelling case for investors looking to balance risk and return, especially in a market where recession fears loom large.​