The Anatomy of a Rate-Cut Cycle

With the Federal Reserve having reduced its target for the federal funds rate in September—and at the time of writing, a high likelihood of additional cuts at coming meetings—many community bank portfolio managers may be asking themselves a number of questions regarding both the policy outlook and its impact on the yield curve generally. 

While nobody—including those at the Fed—has a crystal ball, a discussion about the current climate and range of potential outcomes can inform both portfolio strategy and broader balance sheet strategy for years into the future.

What we know

While there have been many headlines written recently about the Bureau of Labor Statistics (BLS) and its monthly report estimating the state of the job market, two things are fairly clear:

1. While generally positive, growth in nonfarm payrolls had already been slowing since the end of last year.

2. The size of recent benchmark revisions indicates that the labor market is somewhat weaker than previously believed.

Because labor market strength was a key part of why the Fed had previously exercised patience in lowering its target for short-term policy rates, the aforementioned rate cut in September and any additional cuts at future meetings are a logical reaction to new and changing information. 

However, it is important to remember that inflation metrics, including the Fed’s preferred measure of Core Personal Consumption Expenditures (Core PCE), remain above its stated inflation target of approximately 2.00%. Under the Fed’s existing monetary policy framework, this limits how far policy rates can decline, because rates that are too low may cause above-target inflation to accelerate further.

What we don’t know

That being said, “existing” could prove to be a key word from the previous sentence. Though Fed chair Jerome Powell reiterated a longer-run inflation target of 2.00% during the Fed’s annual economic symposium at Jackson Hole in late August, his term as chair ends in 2026. At the time of writing, a clear successor has not yet been named, so it is impossible to assess how (or whether) the Fed’s policy objectives might change under different leadership. However, the possibility of such a shift needs to be acknowledged.

Regardless of what happens with Fed personnel, both the ending point for the federal funds rate and its impact on the shape of the yield curve are likely to more directly affect community bank balance sheets. Market participants generally anticipate between five and six 25-basis-point (0.25%) cuts to the fed funds target rate through the end of 2026, resulting in a terminal rate of approximately 3.00%. This, of course, influences various items on the balance sheet—deposit rates, wholesale funding levels and yields on floating-rates loans or securities, to name a few—in a fairly straightforward manner. However, the outlook regarding shape of the yield curve is somewhat less clear.

The most commonly cited measure of yield curve slope, and one this column often references, is the difference between the two-year and 10-year Treasury rates (often referred to as 2s-10s). After one of the longest and deepest inversions in modern history, 2s-10s returned to positive territory in the latter part of 2024 and has remained at approximately 50 basis points (0.50%) for most of the past six months.

While a steeper yield curve has considerably eased pressure on bank profitability, a review of 2s-10s over the past few interest rate cycles (see chart) shows that the curve is still relatively flat by historical standards. Over the past four decades, 2s-10s has averaged roughly 100 basis points (1.00%), with cycle peaks of about 270 basis points (2.70%).

However, it is important to note that reaching previous cycle peaks typically occurred because of aggressive easing by the Fed, which was frequently accompanied by a recession. While a similar sequence of events cannot be completely ruled out for the current cycle (see comment above about the lack of a crystal ball), the persistence of above-target inflation reduces the Fed’s ability to pursue the type of easing needed to reach those peaks. Given the different set of circumstances today, this raises the questions of what peak curve slope might be for this interest rate cycle, as well as how the yield curve shifts in order to get there.

Tying it all together

From a portfolio management perspective, these questions matter, because the investments that outperformed during previous Fed easing campaigns may not perform as well during the current cycle. In the previous easing campaigns, the appropriate response for a downward curve shift led by short-term rates (commonly referred to as a bull-steepener) was to extend duration and add call protection. 

However, the current environment creates potential for a scenario where short-term rates decline and longer-term rates move higher (which we’ll refer to as a pivot-steepener). This scenario—and especially one with lower levels of peak curve slope—is likely to favor moderate-duration investments like mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs) that generate higher yields by providing lower levels of call protection. 

Given sizable differences between the appropriate responses, thoughtful discussion around existing portfolio holdings and any adjustments to portfolio strategy should be considered as part of your bank’s planning for 2026 and beyond.