Fed Cuts on Hold … Not Indefinitely

May 14, 2024

By Richard Cochinos, CFA®, FRM,® CAIA®
Senior Porfolio Manager, APCM

The first four months of 2024 have dramatically shifted the likelihood of Federal Reserve rate cuts by year-end (Chart 1). Initially a promising year for markets, April witnessed a downturn in both stocks and bond prices driven by concerns over higher US inflation. Market discourse now revolves around whether Federal Reserve cuts are merely postponed (our view) or if the terminal rate exceeds initial expectations. With both factors being priced in, the yield curve has bear flattened (rising short-term rates relative to long-term interest rates), while the higher discount rate has eroded returns.

We see this as temporary, and emphasize the attractiveness of a diversified and high quality fixed income portfolio over the next 12-24 months is the best it has been in nearly 20 years. It is no exaggeration this is a golden age for fixed income portfolios. Firstly, we’ll delve into the recent Fed meeting and then discuss its implications for the rates market.

Source: Bloomberg

Federal Reserve Policy Overview

On May 1, the FOMC maintained the overnight discount rate in the target range of 5-1/4 to 5-1/2 percent, a range it has upheld since July 2023. To contextualize, this marks the highest federal funds rate since 2000 and the longest period of maintaining its peak rate since 2006, when rates remained at 5.25% for 12 months. The lack of significant progress in inflation, particularly in services inflation, has compelled the committee to exercise patience, prolonging the restrictive stance beyond initial expectations. Rate cuts (or hikes) constitute the FOMC’s primary tool, yet they are notably blunt and typically only deployed when economic momentum stagnates. Given the robust state of the US economy in early 2024, rate cuts remain improbable in the near term.

An additional lever employed by the FOMC is the balance sheet. The balance sheet peaked at $9tn in April 2022 and has been declining since, a process known as quantitative tightening (QT). With US rates fluctuating between 4.5% and 5.2%, the Fed began a highly anticipated tapering of its balance sheet reduction, now capping Treasury reductions at $25bn/month (down from $60bn previously) while maintaining the cap on MBS at $35bn. Balance sheet impacts on both market prices and the economy are challenging to quantify, but broadly as the Fed invests less in US fixed income securities, the private market must absorb more to maintain stable yields. Slowing its tapering, should help slow the upward pressure on yields, everything else left equal.

APCM Impressions

The Fed’s policy statement remained largely unchanged, acknowledging the stall in inflation progress. Considerably firmer wage and economic data support this stance. Overall, the communication in the press conference leaned dovish. Chair Powell reinforced the still anticipated future cuts, with little probability assigned to hikes.

Implications for the Fixed Income Outlook

We anticipate that recent data will postpone the Fed’s policy rate cut this summer, with the commencement of cuts likely delayed until September or December. That said, the Fed is acutely aware of the strains in the US economy given the prevailing rates and now perceives its dual mandate (full employment AND price stability) as approaching better equilibrium. This marks a significant shift in communication, as lower inflation or higher unemployment is now deemed sufficient for the Fed to ease policy.

Translating this into market prices

In the current environment, we foresee pockets of weakness are likely to continue appearing, even if average economic and corporate fundamentals remain robust. US Rates, both in nominal and real terms, are near 20-year highs and restrictive. Consequently, we would expect greater dispersion among industries, sectors, and issuers in the coming year, making it an opportune time to be an active fixed income investor. Even if restricted to Investment Grade quality, it is possible to construct a fixed-income-only portfolio yielding 5-6%, with a duration of 4 years and volatility around 3%.

Such elevated starting yields bode well for future capital appreciation and we tend to favor short to intermediate maturities. Globally, dispersion is not limited to the US only. As the outlook for inflation, growth and central bank policy diverge among developed countries, sovereign bond performance is likely to diverge as well.

Front end is attractive The asymmetry of the Fed’s approach shifts the balance to an attractive front-end that likely has a “ceiling” above it. While we sit close to neutral duration in our longer term portfolios, where we hold overweights is in short duration accounts . As can be seen in Chart 2 below, the 3y and under part of the curve has been the main money-maker for Investment Grade paper in 2024 (Chart 2).

Cautious long end We remain more cautious on belly-to-long bonds given supply concerns the next few years and what looks to be higher than expected debt servicing costs. Term premia in these rates sits at or below zero, compared to 50-75bps on average.

Overweight on MBS The front-end back-up creates opportunity to add yield and we see newly-issued MBS as one of the most attractive asset classes in Fixed Income currently, with >6% yields possible with virtually no credit risk. U.S. agency mortgage-backed securities still hold the potential for spreads to tighten once we gain more clarity on the timing of Fed rate cuts, which should reduce interest rate volatility (Chart 3).

Neutral to mild underweight IG In credit markets, we see attractive valuations and resilient fundamentals in several areas of securitized credit. Our portfolios are generally neutral on investment grade corporate credit given tight spreads as defaults may begin to rise given an elevated rate environment and potential cyclical slowing (Chart 3).

International rates look attractive, but they’re not for everybody The U.S. may continue along a strong growth trajectory, accompanied by still-high inflation. This makes U.S. bonds generally less appealing than those in many other developed markets such as the UK, Europe and Canada. Fixed income markets are already starting to price interest rate moves ahead of the Fed, as these countries are far more exposed to a global growth drag.

Source: Bloomberg

Source: Bloomberg