The Fed Funds rate rose from 0.25% in 2022 to more than 5.5% by 2024 thanks to stubborn inflation following COVID-19.
While these interest rates have fallen to about 4.5% today, the futures market no longer expects to see the return to normal they thought likely just a few months ago. Instead, the futures market projects interest rates will hover around 4% by the end of this year and remain above 3% by the end of next year.
In this article, we’ll look at what this new normal means for your portfolio and steps you can take to mitigate the effects of inflation.
What’s Driving Interest Rates?
The COVID-19 pandemic is widely seen as the cause of the initial spike in inflation around 2020 and 2021. While the relief efforts helped avoid a devastating recession, printing money always comes at a cost. A sharp rise in consumer spending and subsequent supply chain disruptions led to a spike in inflation through 2023 and 2024.
The Fed Funds rate fell in recent months but could level off as the Fed re-assesses the economic outlook. Source: TradingEconomics
Fast forward to today, inflation is coming down and the economy remains strong on paper, but the Federal Reserve doesn’t think the economy is out of the woods yet. The Consumer Price Index rose 2.9% in December 2024, but more importantly, the incoming Trump administration could introduce tariffs that can reignite inflation.
The two biggest uncertainties are the magnitude and impact of potential tariffs and the pressure the Trump administration will put on Jerome Powell to influence interest rates. While the Federal Reserve is ostensibly an independent institution, President Trump has already said that he would “demand that interest rates drop immediately.”
Adjusting to a New Normal
Rising inflation is typically bearish for stocks and bonds. That’s because bond prices move inverse to bond yields, which would have to rise to beat higher inflation. Meanwhile, stocks typically see slower growth due to more expensive borrowing costs, which should reduce price-earnings multiples, and, in turn, stock valuations.
However, today’s environment is one where interest rates are falling more slowly than expected rather than rising higher. In other words, the changes to valuation stem from a recalculation of expected returns rather than declining real returns. This means investors may want to be less reactionary and more prudent in their decisions.
For example, many fixed income investors focus on minimizing duration during rising interest rate environments. However, when interest rates are falling more slowly than anticipated, a barbell strategy might make more sense, where investors hold both shorter-term duration and longer duration while underweighting intermediate durations.
In addition, credit selection becomes much more important. High-quality investment-grade corporate bonds in the five- to seven-year part of the curve may offer an attractive risk-adjusted yield compared to Treasuries. Meanwhile, municipal bonds could be attractive to investors in higher tax brackets due to their higher tax-equivalent yields.
Strategies for Your Portfolio
Fixed income is one area where active management tends to outperform passive management. Due to their structure, passively managed funds, like the iShares Core U.S. Aggregate Bond ETF (AGG), reward the most indebted borrowers, resulting in less diversification and potentially lower credit quality than active alternatives.
For instance, the actively managed JPMorgan Core Plus Bond ETF (JCPB) generated an average three-year rolling excess return of 107 basis points over AGG. The JPMorgan Core Bond Fund (WOBDX) outperformed AGG by 20 basis points on average (net of fees) during 71% of three-year rolling periods over the past 15 years, a strong, robust track record.
Popular Active Bond ETFs
These are sorted by their one-year total return, which ranges from 3% to 7%. They have an AUM between $180M and $17B, with expenses running between 0.18% and 0.71%. They are currently yielding between 3.4% and 6.3%.
| Name | Ticker | Type | Actively Managed? | AUM | 1-year Total Ret (%) | Yield | Expense |
|---|---|---|---|---|---|---|---|
| JPMorgan Income ETF | JPIE | ETF | Yes | $2.39B | 7% | 5.9% | 0.4% |
| Fidelity Limited Term Bond ETF | FLTB | ETF | Yes | $184M | 6% | 4.6% | 0.25% |
| PIMCO Active Bond ETF | BOND | ETF | Yes | $5.12B | 4.3% | 5.2% | 0.71% |
| Fidelity Total Bond ETF | FBND | ETF | Yes | $16.6B | 4% | 6.3% | 0.36% |
| JPMorgan Municipal ETF | JMUB | ETF | Yes | $2.02B | 3% | 3.4% | 0.18% |
The Bottom Line
Interest rates are likely to continue coming down from their post-COVID highs, but the pace of the decline could start to become meaningfully slow. With the threats of tariffs and other risks, the futures market expects interest rates to remain above three percent for at least the next two years and above four percent for the next year.
One way to adjust to these risks is to implement a barbell strategy, where you are underweight intermediate duration bonds. Fortunately, there are several active funds that leverage these kinds of strategies, which is much more practical than selecting and managing a portfolio of individual bonds.
