Investing Strategy for Fed Cuts with 3% Inflation

What pros wish you knew about Fed cuts with ~3% inflation

Fed cuts with ~3% inflation aren’t a green light to buy everything, sorry, I know that’s the itch right now. Cuts are a reset to the discount rate and term premia, not a bailout. Earnings still have to do the heavy lifting. And in Q4 2025, with cash still pretty competitive and real yields not exactly cheap, the playbook is different than it was during recession scares or the 1% inflation world we all kinda miss.

Here’s how I’m framing it, and yeah, I’ve wrestled with the same questions you are. When inflation runs near 3%, the real rate backdrop matters a lot. Long bonds can rally on cuts, but it’s usually two steps forward, one back as term premium wiggles and growth data whipsaw weekly. Cash still pays, north of 4% in a lot of money funds this year, so the bar to take duration or equity risk has to clear an actual hurdle, not a zero-yield nostalgia trip.

What you’ll get from this section: a clean framework for the mix, how much duration to add, which equity factors make sense when real yields bite, and where carry still pays without leaning into default land.

Historical context helps, mid-cycle cuts don’t break things; they rebalance them. In 1995, the Fed eased after the 1994 shock, and the outcome was balanced: equities did fine and duration helped as yields drifted lower. Fast forward to 2019: the Fed cut 75 bps in three moves. The S&P 500 returned about 31.5% that year (total return), the Bloomberg U.S. Aggregate Bond Index returned ~8.7%, and U.S. investment-grade spreads tightened from roughly 160 bps in early 2019 to near 100 bps by year-end (2019 figures). Credit was fine because growth held; the high-yield default rate hovered near the low 3% area in 2019 according to Moody’s. Point is, mid-cycle cuts have delivered balanced outcomes when growth doesn’t crack.

Where does that leave us in 2025? With a few practical questions:

• Duration: add some, but respect the path. Real yields still matter at ~3% inflation, carry on the long end can help, but drawdowns are real if term premium backs up for a month or two.
• Equities: quality cash flows get re-rated as discount rates reset, steady margins, pricing power, and clean balance sheets. I know, not sexy. But dependable. Value-with-quality and cash-compounding growth both make sense.
• Credit/carry: still pays if growth holds, stick to higher-quality high yield and short IG where you’re not underwriting a downgrade cycle. Keep an eye on interest coverage trends; they’re the tell.

I might be oversimplifying a bit, there’s path dependency everywhere, but the core idea stands: cuts are a valuation reset with earnings in charge. We’ll map that to positioning, how to size duration, which equity factors to favor, and where carry still works, without pretending it’s a free lunch.

Fixed income first: extend duration, keep a ladder, and be honest about real returns

Bonds are finally doing bond things again, carry that matters, price moves that aren’t just noise, and an actual term premium. With the Fed easing as inflation glides toward ~3% this year, fixed income is back to being the first building block, not an afterthought. Quick check on the dashboard I keep pinned: as of late October 2025, the 5-year Treasury is hovering near ~4.1%, the 10-year around ~4.2%, and the 10-year TIPS real yield is roughly ~1.9% (H.15/Bloomberg). That implies 10-year breakeven inflation near ~2.3%, use that as your North Star for TIPS versus nominals, not a gut feel after your second espresso.

How to structure it in practice? Here’s the playbook I’m using with clients and in my own accounts, with a few scuffs from the real world.

• Laddering and liquidity: Keep a live ladder in the front end, 6 to 24 months of staggered maturities for liquidity and known needs. Why that window? Because bills/short notes still pay and refi risk is zero. As policy rates drift down, reinvest coupons and maturing rungs slightly longer, think rolling 1-2 year rungs out to 2-3 years, so you keep capturing the reset in yields without betting the farm on any one CPI print or Fed meeting. I’ve learned the hard way that ditching the ladder entirely right before cuts feels smart and then, bam, you need cash for taxes or a tuition bill.
• Duration adds: Start by adding 3-7 year exposure. That’s the sweet spot where carry and roll help, but the mark-to-market pain is manageable if term premium pops for a month. Add 10-20 year selectively on yield spikes, don’t flip the whole book at once. I like setting “step-ins” at spread or yield levels you pre-commit to. If you’re asking, “Why not go all-in long right now?” Short answer: convexity cuts both ways and the path matters. A 30-50 bp back-up in the long end can erase a half-year of carry. Not catastrophic, just annoying.
• TIPS vs. nominals: This is arithmetic, not a vibe. If your CPI path expectation exceeds the market breakeven, tilt to TIPS; if it’s below, take term premium in nominals. Current breakevens sit around ~2.3% on 5s and 10s as of this week. If you believe headline CPI will average closer to 2.7-3.0% over your horizon, TIPS carry that extra expected inflation. If you think it settles closer to 2.2-2.4%, nominals should win. And yes, check the screen, breakevens are market data, not a dinner-table guess.
• Munis for high earners: Favor high-quality (AA/Aa), intermediate maturities (5-12 years) for the best after-tax bang. Mind AMT exposure on certain private-activity issues; it sneaks up on folks. Match duration to liabilities, college in 3-5 years, a home upgrade in ~7, retirement glidepath in 10-20. Simple, maybe too simple, but matching cash flows to cash needs is the whole point of owning bonds.
• Avoid reach-for-yield traps: Be wary of callable structures with ugly convexity that get yanked away when you want the upside and stick around when rates back up. Thin-liquidity preferreds can gap on no news. And unrated credits without real covenants, if you can’t find the downside math in a few minutes, pass. The 50 bps of “extra” yield isn’t free; it’s payment for risk you can’t hedge easily.

Real returns check, one beat I won’t stop hitting. With 10-year TIPS near ~1.9% real and CPI prints hovering around ~3% year-over-year in recent months, you can actually lock in a positive real yield on the long end. That hasn’t been consistently true for years. Does that mean back up the truck? No. It means size it rationally. I might be oversimplifying (I do that), but the hierarchy is: secure liquidity, extend duration in steps, use breakevens for TIPS vs. nominals, and resist shiny yield objects.

One last mental model I repeat, sometimes out loud: “Will I regret owning this if the 10-year sells off 40 bps next month?” If the answer is “probably not, because I’m laddered and still collecting 4%+ on the belly,” you’re in the right zone. If the answer is “uh, yes,” you moved too fast. I’ve done both; one of them lets you sleep.

Equities in a cut cycle: quality cash flow > pure “rate beta”

When the discount rate moves down but inflation isn’t dead, the market usually re-rates quality first. Not the moonshots. I’ve seen this movie more times than I’d like to admit. With 10-year TIPS around ~1.9% real and CPI running near ~3% year-over-year in recent months, you’ve still got a positive real curve to discount cash flows against, but not a free pass for businesses that need cheap money to survive. Said another way, lower rates help, but a real cost of capital still bites.

So what wins? Companies that don’t need the capital markets every quarter and can self-fund growth. I mean the boring good stuff: high ROIC, stable margins, and low net use. If you want guardrails, I use rough hurdles like ROIC > cost of capital by 300-500 bps, gross margins that don’t collapse 500 bps at the first whiff of price competition, and net use under ~1.5x unless the cash conversion is bulletproof. These names benefit when discount rates fall, yet their equity story doesn’t hinge on refinancing windows staying wide open.

• Sector tilts that often work
  • Software with real FCF: Not “adjusted EBITDA until we’re profitable,” but 15-30% FCF margins, net retention north of 110%, and pricing that sticks. Lower WACC bumps terminal value, but the thesis isn’t just multiple expansion; it’s compounding cash.
  • Healthcare services: Utilization has normalized, and the revenue cycle/outsourced care models with contract visibility tend to hold margins when input costs jiggle. Watch payer mix, small changes matter.
  • Payment networks: Volume growth plus take-rate discipline equals cash machines. Cross-border keeps surprising when travel holds. If nominal GDP is okay, they hum.
  • Staples with pricing power: Not all staples, ones with brand heat and mix upgrade. If CPI is ~3%, a 2-4% list price is plausible without destroying unit volume. Gross margin stability is the tell.

Now, cyclicals. Be selective. Industrial names with actual backlogs and service attach rates have a cushion; hope-and-a-prayer order books don’t. If you’re building a simple checklist, ask: backlog-to-revenue > 1x? Aftermarket/service > 25% of sales? If yes, you’ve got some protection when PMIs wiggle for a quarter or two.

Don’t torch your defensives either. If the Fed’s cuts look more like insurance than a recession call, which is how it feels right now, defensives can still compound. And if growth wobbles for a quarter, you’ll be happier holding a few cash cows that clip a steady dividend and buy back stock. I know, it sounds obvious. It’s obvious until your screen is flashing green and you sell your ballast at the bottom.

Small and mid caps? Improvements usually show up later in the cut cycle as financing costs reset and lenders relax covenants a bit. The trick, sorry, the discipline, is to dollar-cost average. Don’t try to nail the inflection. Spread entries over quarters, not weeks. As real rates stay positive (again, TIPS near ~1.9% real), the market still discriminates. Balance sheets with floating-rate scars will need time.

On valuation, lower rates are not an excuse to pay any price. Re-underwrite with an updated WACC and realistic terminal assumptions. Quick mental math: if your nominal WACC drops 75-100 bps and your terminal growth stays the same (or maybe you shave it if long-run inflation settles near ~2-2.5%), the DCF lift is nice, not magical. I’m oversimplifying, but I’d rather trim terminal growth by 25-50 bps than stretch a five-year free cash flow ramp I don’t believe. Oh, and sanity-check multiples against through-cycle margins, 2021 peak margins aren’t a baseline.

Rule of thumb I keep taped to my screen: if the thesis needs both falling rates and re-accelerating unit growth to work, it’s not quality, it’s rate beta with lipstick.

One last thing because it gets lost in the noise: cash conversion. If a business can turn 90-100% of EBIT into free cash over time, every 25 bps cut in the discount rate shows up faster in your valuation math. That’s the point here. In this part of the cycle, cash beats story, and durable beats exciting. I’ve chased both; only one paid my mortgage on time.

Credit and credit-like: take carry, but set guardrails

Carry still pays in 2025, but this is where underwriting actually matters again. When the market gets comfy that the Fed will “handle it,” people forget the basics. I keep it boring on purpose: avoid CCC landmines, prefer structure over sizzle, and let the Fed do some work for you when it finally cuts. You don’t need heroics to hit your bogey; you need a process that doesn’t blow up on one bad print.

Investment-grade (IG) as the core carry sleeve. IG should be your ballast: broad, liquid, and reasonably priced for the risk. Ladder maturities to spread reinvestment timing, yes, it’s Finance 101, but it works. And be careful with rate-sensitive financial hybrids and AT1-style instruments; they can trade like equity on bad days and get dinged by both spread and duration. For context, the ICE BofA US Corporate Index yielded roughly 5.5-6.0% at points in 2024 (ICE/BofA data), with option-adjusted spreads running near ~120 bps around mid-2024. Not cheap like 2020, not frothy either. Today, I want plain-vanilla senior unsecured from durable cash machines, not cute structures with call features that only favor the issuer.

High yield: up-in-quality, and read the docs. If you want carry with some kicker, keep it BB/B and diversify. Default cycles don’t disappear because of one or two rate cuts; they just lag. S&P Global’s long-run averages (1981-2023) show one-year default rates of ~0.99% for BB, ~4.03% for B, and ~26.63% for CCC/C. That spread between B and CCC is the whole story, carry isn’t free. Use HY ETFs for liquidity and price discovery, then layer in an active manager who actually fights on covenants; that’s where the alpha shows up in late-cycle skirmishes. And please, watch issuer concentration from private equity-heavy capital structures that have thin cushions, debt got layered weird during 2021-2022 and we’re still cleaning it up.

Loans vs bonds as policy rates fall. Loans feel great when SOFR is high and coupons float, but as policy rates edge down (whenever the Fed decides to turn the dial), those coupons reset lower. That’s the point. In 2024, SOFR hovered around ~5.3% for much of the year (New York Fed), which propped up loan coupons. But as short rates normalize, I shift incrementally from loans to fixed-rate HY/IG, when spreads pay you. Don’t move just because “rates are falling”; move when the spread compensates for liquidity, call risk, and downgrade risk. Over-explaining a simple idea here: a floating coupon drops pretty fast after cuts; a fixed coupon doesn’t. So, you lock the fixed one when it’s still juicy. That’s it.

Structured credit: prefer seasoned and senior. Stick to senior tranches with strong credit enhancement in established shelves. Seasoned collateral with visible realized losses and stable servicer behavior beats shiny new structures every time. If you can’t model it on a napkin, cashflows, triggers, loss coverage, skip it. Esoteric stuff with levered residuals looks smart until it isn’t. And it ain’t fun explaining to an IC why you owned the only tranche that became illiquid for six months.

Tax-aware investors: do the after-tax math. At a 37% top federal bracket, tax-equivalent yield matters. As a reference point, AAA muni yields were around ~3.0-3.3% at times in late 2024 on the MMD curve; tax-equivalent that for a 37% bracket and you’re near ~4.8-5.2% before state taxes. In the same period, IG corporates ran ~5.5-6.0% (ICE/BofA). At ~3% inflation, real after-tax is what you actually spend, not the headline coupon. And taxable municipal bonds can outcompete corporates after-tax for many high earners, especially when you factor call structures and potential state tax exemptions.

Simple guardrails I actually use:

• Avoid CCCs unless the upside is crystal and near-term; the base rate math isn’t kind (see S&P data above).
• Ladder IG maturities; don’t bunch everything at the same duration node.
• Keep HY up-in-quality (BB/B); pair ETFs for liquidity with active funds for covenant scrutiny.
• Rotate loans to fixed-rate credit as policy rates fall, only when spreads compensate.
• Structured credit: seasoned, senior, strong enhancement; skip what you can’t pencil simply.
• Run after-tax comparisons: high-quality munis or taxable munis often win in high brackets at ~3% inflation.

And look, I’ve broken these rules before. It worked right up until it didn’t. Guardrails keep you compounding when the tape gets noisy, and that’s the whole point of carry.

Household moves that actually change outcomes: cash, mortgages, and taxes

Portfolio alpha starts at the kitchen table. Seriously. In Q4, with the Fed easing into a lower-rate regime while inflation still hangs around ~3% this year, a few unglamorous tweaks can move your net worth more than the next fancy fund pitch. I know that sounds boring. Good. Boring compounding works.

Cash buckets you’ll actually stick with. Keep 6-12 months of essential expenses in high-quality cash instruments, top-tier online savings, Treasury-only money funds, 4-26 week T‑Bills. Why not “maximize yield at all times”? Because emergency cash is about certainty and same-day or T+1 liquidity. As policy rates drift down later this year, set a calendar reminder every 60-90 days to renegotiate bank yields or roll into short Treasuries/CDs. Two notes people miss: (1) T‑Bill interest is exempt from state and local tax, which matters if you live in CA/NY/NJ; (2) FDIC/NCUA insurance is $250,000 per depositor, per bank, per ownership category, spread balances if you’re above that. And yes, T‑Bills auction weekly across 4, 8, 13, 17, 26, and 52 weeks, which makes laddering dead simple.

Mortgage/refi reality check. If rate cuts open a refi window, run the breakeven before you sprint. Quick math: Breakeven months = closing costs ÷ monthly payment reduction. $6,000 costs / $220 saved = ~27 months. Planning to move in 18 months? Don’t bother. Also, if cash flow allows, a 20-year or 15-year term can slash lifetime interest even if the payment bumps a bit. One more thing, don’t forget points vs no-points pricing; compare APRs and ask the lender for a par-rate quote to strip out noise. I made this mistake in 2019 and paid a point I didn’t need. Still annoys me.

Roth conversions when volatility gives you a sale. If markets wobble in 2025 and your IRA assets dip, partial conversions at lower prices can reduce lifetime taxes by shifting future growth into tax-free status. Watch the collateral effects: conversions raise AGI, which can trigger the 3.8% Net Investment Income Tax thresholds ($200,000 single / $250,000 MFJ; statutory) and affect Medicare IRMAA two years forward. To avoid penalties, align with the estimated tax safe harbor, pay 110% of last year’s tax if your prior-year AGI was above $150,000 (or 100% if at or below), or project your current-year liability tight. Not fun, but it keeps the IRS out of your inbox.

Tax-loss harvesting without breaking the engine. Even in an up year, sectors chop around. You can harvest losses and keep your factor exposures. The key is substitutes: swap an S&P 500 fund for a different provider’s S&P 500 fund? Wash-sale risk. Prefer a close, but not “substantially identical”, replacement, like S&P ↔ total market tilt, or sector ETF ↔ a diversified factor ETF that keeps beta/size close. Remember the wash-sale window is 30 days before and after the sale (that’s a 61-day lookback including the sale date; IRC §1091). And yes, harvested capital losses can offset gains and then up to $3,000 of ordinary income per year, with the rest carrying forward.

I Bonds and Treasuries. I Bonds are still useful for inflation hedging, but capacity is the choke point: the annual purchase limit remains $10,000 per person via TreasuryDirect, plus up to $5,000 more with a federal tax refund in paper form. Set expectations. For liquidity, T‑Bills in taxable accounts stay attractive even as yields slide because they’re state-tax exempt and settle fast. If you need cash next quarter for a roof, a 13-week bill that matures right before the contractor shows up beats hoping your bank doesn’t reprice your savings rate while you sleep.

Confusing? Yeah, there’s nuance. The gray areas: “substantially identical” isn’t perfectly defined, IRMAA brackets creep, and lenders’ fee sheets are… creative. But these are controllable levers. And I’ll be honest, this is the stuff I obsess over at 6 a.m. with coffee because it actually moves the needle.

One last nudge, if your plan lives in your head, it’s not a plan. Put dates on the calendar: cash-rate check every quarter, refi breakeven if your quoted rate drops 75-100 bps, harvesting review after big sector moves, and a Roth conversion dry run when volatility shows up. It sounds tedious. It’s the part that compounds.

A simple 12-month playbook (and a sanity check to close the loop)

Here’s a no-drama plan for a 3%‑ish inflation cut cycle in 2025. We’re assuming the Fed starts trimming off the 5.25%-5.50% target range set in 2023-2024, and does it carefully. Patience over heroics. Also, quick reality anchors: in 2024, high yield option‑adjusted spreads sat mostly in the 300-400 bps zone (ICE BofA data), and IG spreads hovered near ~100-120 bps. Translation: credit wasn’t screaming cheap last year, and unless something breaks, you probably won’t be paid for swinging too hard early this year.

Quarter 1-2 from the first cut

• Extend duration, moderately. Keep your core bond fund as the anchor and add some 7-10 year Treasuries/IG to lift duration by ~1-2 years versus your current stance. No need to jump to 20+ years unless your liabilities demand it. FWIW, when rates fell off the 2023 peak, the 7-10y sleeve did the heavy lifting; it’s usually the sweet spot for a softening cycle.
• Keep a 6-24 month cash ladder. T‑Bills still matter. In 2024 the 3‑month bill yielded around the mid‑5s at times; that’s rolled down, but the ladder provides reinvestment flexibility as cuts arrive and it’s state‑tax friendly in taxable. Match maturities to known cash needs (property tax, tuition, roof guy).
• Tilt equity toward quality and consistent cash flow. I mean boring quality: high free‑cash‑flow margins, net cash or low net use, dividend growth > inflation, and pricing power. When policy is easing with inflation near ~3%, steady cash beats story stocks, most of the time.

Quarter 3-4

• Reassess credit spreads. If HY OAS sits near that 350-400 bps “fair” zone again (it did much of 2024), favor IG over HY for new dollars. If we widen past ~500 bps on real recession risk, different conversation.. but base case, stay up in quality.
• Shift floating‑rate to fixed‑rate carry. As cuts take hold, trim some bank loans and floaters and add intermediate IG or agency MBS. You’re locking carry before the curve fully reprices. Keep loans/HY for diversification, just smaller.

Rebalancing triggers

• ±5% bands around target weights. If equities run and breach the band, harvest and refill bonds/cash; if bonds rally hard on cuts, peel gains to fund equities or alternatives.
• Harvest winners to fund laggards. Use sector/ETF sales to avoid single‑name tax landmines when you can. Watch wash‑sale rules, yes, “substantially identical” is still fuzzy.
• Taxes and costs first. Use tax lots. Coordinate capital gains with bracket management and IRMAA tiers (Medicare thresholds crept higher in 2024; still bites). Don’t churn for 10 bps.

Risk controls

• Cap HY/loans at a size you can sit with in a 15-20% drawdown, write the number down. If your stomach says 5%, it’s 5%, not 12%.
• Avoid single‑name concentration in speculative tech or levered cyclicals. Own broad baskets if you want the theme. No more than 2% per single risk bucket; I learned that one the hard way in 2008.. and 2022 reminded me again.

Position sizing guide (illustrative, not gospel)

• Core bonds 30-45%; of that, 10-15% in 7-10y duration by mid‑year if cuts proceed.
• Cash/T‑Bill ladder 5-15% maturing every 1-3 months out to 24 months.
• Equities 45-60% tilted to quality/defensives; keep a small sleeve for cyclicals but don’t let it run your life.
• HY/loans 0-8% total, sized to your sleep level.

I said I’d come back to term premium, short version: if it stays positive, you’re paid to move out the curve, but not to the moon. The 7-10y pocket is your workhorse.

Sanity check back to the opener: a cut cycle with ~3% inflation rewards patience and balance, not max risk. The 2024 setup told us spreads can look fine, not cheap, for a long time. So this year, keep the ladder, extend duration a bit, prefer IG over HY unless spreads blow out, and rebalance on a schedule. If you remember one thing, remember that. Your 2025 plan will probably do just fine.

Frequently Asked Questions

Q: How do I adjust my bond duration if the Fed cuts while inflation is ~3%?

A: Short answer: add some duration, don’t go hero. In Q4 2025, I’m nudging average duration out 1-2 years from wherever you sit today. Practical ways: (1) Barbell with 3-6 month T‑Bills plus 7-10 year Treasuries; (2) Build a 1-5 year Treasury/IG ladder and drip into the 10‑year on red days; (3) If you want ballast, own a sleeve of 10-20 year Treasuries or an intermediate core bond fund, but keep sizing modest (think 10-20% of fixed income) because term premium can wiggle. If real yields back up 25-40 bps, add another clip. I know, it’s messy, cuts help duration, but with ~3% inflation, it’s two-steps-forward-one-back. Keep a cash sleeve since money funds still pay north of 4% this year, so you’re not being penalized while you wait.

Q: What’s the difference between buying long Treasuries now and waiting until cuts actually happen?

A: Now: you’re paying today’s price for expected cuts already baked into the curve. You get carry/roll-down and convexity if growth cools faster. Risk is a pop in term premium or a hot data print that pushes yields up short-term. Waiting: you reduce timing regret, but if the market front-runs the Fed (it usually does), you may miss a chunk of the move. A simple playbook, scale: buy a third now, a third on a 15-25 bp selloff, a third after the first cut if the 10‑year real yield is still attractive. Use liquid tools (Treasuries, ladders, or 7-10 year ETFs) so you can change your mind without drama.

Q: Is it better to keep cash in money funds or rotate into credit and equities right now?

A: Use tiers. Tier 1: keep 6-12 months of spending in cash/treasury bills, money funds above 4% this year are fine. Tier 2: for income without living in default land, consider short/intermediate IG (ladder 1-5 years), agency MBS, and TIPS if you want inflation linkage; target portfolio yield that beats cash by ~100-150 bps after fees. Tier 3: for upside, tilt equities to quality, dividend growers, and cash‑rich tech/healthcare; add a bit of value and low‑vol for balance. If you really want carry but hate credit risk, alternatives to HY are: barbelled T‑Bills + 7-10 year Treasuries; or a TIPS/IG combo. If spreads gap wider, be ready to rotate some cash into IG first, HY second. No need to force it, cash is still competitive.

Q: Should I worry about stocks if the Fed cuts, does that mean a recession is coming?

A: Not automatically. Mid‑cycle easings often rebalance, not break. In 1995, equities did fine as yields drifted lower after the 1994 shock. In 2019, after three cuts, the S&P 500 returned about 31.5% and the Bloomberg U.S. Aggregate returned ~8.7%; IG spreads tightened from ~160 bps to ~100 bps (2019 figures). The catch now is earnings have to carry the load because real yields aren’t cheap. So keep the equity mix biased to quality balance sheets, consistent cash flow, and pricing power. If growth stays okay, stocks can work; if growth cracks, your duration sleeve is the shock absorber. I’d worry more about overpaying for story stocks than about the act of cutting itself.

@article{investing-strategy-for-fed-cuts-with-3-inflation,
    title   = {Investing Strategy for Fed Cuts with 3% Inflation},
    author  = {Beeri Sparks},
    year    = {2025},
    journal = {Bankpointe},
    url     = {https://bankpointe.com/articles/investing-for-fed-cuts-3-inflation/}
}