On Our Way to 2%
Strategy
The number one reason the Fed had been raising interest rates for nearly two years is INFLATION. Chairman Powell has stated repeatedly that his target for inflation is 2.0%. The year-over-year inflation rate is 3.2% but using the 6-month average, the level is 1.9%. Clearly, inflation is headed towards the Fed’s 2.0% target. This has resulted in the market pricing in six rates cuts next year in 25 basis point increments spread throughout the year. The Fed’s projection is for two or three rate cuts.
Despite GDP increasing at 4.9% in the 3rd quarter, interest rates fell sharply during Q4. There is a month or two lag for the GDP release, so the news hit the market in the 4th quarter. The S&P 500 Index advanced 13% in the last quarter of the year as markets determined Fed rate hikes were done. Bond prices also rose sharply pushing the YTD return for government bonds to 4% - 5% and corporate bonds posted total returns of 7% - 10%. This is in sharp contrast to 2022, which was the worst year on record for fixed income returns.
We now have a sharp difference in opinion (between the market and the Fed) for the number of rate cuts next year, the timing of the first cut, and whether we will have a soft landing or a mild recession. At the same time, the Fed is still talking about possible rate hikes while the market is focused on rate cuts. It’s up to the data to determine who is right. If the data is soft and inflation continues to fall, interest rates should fall as well. If the Fed is right and inflation turns up, then interest rates may rise. The equity markets will likely move in the opposite direction of interest rates. The Fed rate hike cycle in 2022 and 2023 was the most aggressive on record. Seemingly, something is bound to break. The consumer is stretched, student loan repayments have started and GDP for Q4 is expected to be between 1% and 2%. The economy is beginning to show signs of slowing, and inflation is falling. Softer growth combined with disinflation provides the FOMC with evidence that cutting interest rates is appropriate in 2024 although the timing and degree are still suspect.
"MBS are attractive due to strong credit quality, excellent liquidity, and attractive yield."
As we survey the investment options for investors, one sector continues to present excellent value. Mortgage-backed securities (MBS) provide high yields, excellent liquidity, monthly cash flows, and an assortment of market prices that will appeal to many types of investors. Thirty-year pools have yields as high as 5.75% and 15-year pools can generate yields as high as 5.40%. These MBS are issued by government agencies like Freddie Mac, Fannie Mae and Ginnie Mae. MBS are subject to homeowners prepaying their mortgage as rates fall, resulting in the investor getting their investment back earlier than expected. This is called prepayment risk. We manage prepayment risk by buying pools that were issued when rates were lower, so the homeowner’s mortgage rate is lower than where mortgage rates are today. They have no incentive to refinance their mortgage. This means there will be minimal prepayments and the investor’s MBS principal will remain intact for a longer time, providing high income for years. MBS are attractive due to strong credit quality, excellent liquidity, and attractive yield.
We are also proponents of targeted investment grade corporate bonds. Default rates are low, liquidity is good, and the additional yield as compared to a like-maturity treasury security is intriguing in isolation. Our hesitation about the space is currently due to two factors: valuation and the potential of a recession. The option adjusted spread (OAS) measures the extra yield provided by corporate bonds as compared to a like-term Treasury. The St. Louis Federal Reserve tracks the OAS daily. It currently stands at 104 basis points. A longer-term average OAS would be 150 basis points, so valuation isn’t compelling by historical standards. In addition, a recession often causes the OAS to widen. A wider OAS acts in the same manner as higher interest rates. It causes the market value of the bonds to decline. While there are some issuers we would buy today, the market broadly looks expensive when the risk of recession is considered in their valuation.
This last security type is one we have not discussed in many years. Ginnie Mae (GNMA) project loans are commercial real estate securities issued by GNMA providing the investor with the full faith and credit of the United States. The real estate loans are usually multi-family or healthcare related. As interest rates rose in 2022, these securities were repriced to reflect much slower prepayment speeds and longer average lives. Convention had been to price the GNMAs using a 15 CBJ prepayment speed. The higher interest environment resulted in prepayment speeds dropping to 2-5 CBJ. The average life increased from 4 years to 9 years. Investors responded by demanding a higher yield. The yield at 15 CBJ is 7.90% and at 5 CBJ the yield is 4.85%. This is because the bond is selling at a dollar price of $79.50. These securities tend to prepay faster as they age. Given the full faith and credit backing and the potential for the yield to get to nearly 8%, we believe this type of investment is something to consider where appropriate.
Observations and Interest Rate Outlook
Baseball is the only major sport in the U.S. where spectators are encouraged to stretch in order to tolerate sitting for the rest of the game (sorry baseball fans and sports team clients). Thankfully most trips to the ballpark involve other American pastimes of eating stadium food and having adult refreshments. We expect that the rest of this Fed cycle will feel as anxiety inducing as watching a baseball game without the food, beverages or the 7th inning stretch. Some might say that the typical length of our quarterly strategy piece can be equally taxing.
Our theme for 2023 was “higher for longer” and our forecast for Fed policy in 2024 is that the most uncomfortable innings of “higher for longer” will morph into the late 2024 and early 2025 theme of “oops, I did I again.” Specifically, elevated real yields will be the biproduct of subsiding inflation data and expectations with continued restrictive Fed policy. The restrictive policy will be in the form of both sustained Quantitative Tightening (QT) as well as through keeping the Fed Funds Rate near the current level which is at a 22-year high. The market and many of its vocal participants seem to believe the Fed follows the market’s lead. Talk of a “Powell put” and suggestions that Fed rate policy could be accomplished by following moves in the 2-year Treasury yield support a belief of a Fed that reacts to the financial markets. Although the market sends pricing and sentiment signals to the Fed, the inputs to policy are likely far more complex. The reason we believe that real rates are a key barometer for the Fed’s next steps is that Fed officials are keenly aware that in 1976 when the Fed cut rates at a time when the real Fed Funds Rate was negative, it helped to spark the second wave of inflation, requiring a crippling recession to fully defeat inflation. Real yields remain around 2% and as mentioned last quarter, the average going back to 1959 is closer to 3%. Although we may be lulled into expecting the 1% real yields, we have experienced for much of the past 15 years, the level of interest rates needed to fund massive deficits and debt may more closely mirror our long-term experience as opposed to the cheap financing costs enjoyed during the zero-interest rate policy era. Since the recent banking system challenges, it appears the Fed is adhering to the Separation Principal, where rate policy is used to alter financial conditions and the Fed’s balance sheet will be used to support financial stability. As the Fed attempts to normalize their balance sheet through QT, an exercise that should take roughly two more years, it seems that there will be pressure on nominal rates as cashflows and maturities from the Fed’s portfolio are not reinvested, requiring the free market to step in its place. In total, it suggests a longer-term propensity toward higher rates on both a real and nominal basis.
"The Fed hasn’t had to really fight inflation since roughly 1991."
Earlier, we mentioned that we thought the market was going to be incorrect about the timing and amount of Fed cuts in 2024, we also think the market is looking at the reason for Fed action from a vantage point that suffers from recency bias. We think the market has the “why” part of near-term Fed moves wrong. The Fed hasn’t had to really fight inflation since roughly 1991. Since then, it has managed growth pessimism or euphoria, along with the occasional financial system crisis. Before 1990 when inflation-fighting was paramount, Fed easing generally occurred after the official start of a recession. After 1990, Fed rate cuts often occurred before the official start of a recession (three out of five times – two of the easing cycles occurred without a subsequent recession, earning Alan Greenspan the moniker “The Maestro”). Interestingly, Bloomberg has a machine learning Fedspeak model that measures the tone of more than 50,000 Fed news stories and as of early December, the tone of Fed hawkishness had declined to the level experienced in late 2018, just before Powell’s dovish pivot in January of 2019 when he abandoned plans for further rate hikes in that cycle. Bloomberg also offered analysis of the Fed transcripts from 1990 through 2019 which may offer a longer-term perspective on what has prompted the Fed to act in the past. In descending order of frequency as a cause for Fed action over that period the reasons include global growth, tight credit conditions, business investment and output, consumer spending/confidence, and business inventories. Although the service side of the economy has grown over time, it is interesting how the psyche and health of the consumer was near the bottom of the list and global growth, business health, and orderly credit environments were the most frequent reasons for action. It seems like there are many reasons why the current state of the world and market conditions could make the near future rhyme with the past.
In recent editions of Insights, we have discussed some of the same influences that the Bloomberg analysis mentioned above cited for past Fed actions. Global tensions, tighter bank lending standards, euphoric low spreads on lower quality corporate debt, diminished savings balances for individuals, and the consequences of increasing levels of debt as benchmarked against the size of the economy are all areas of concern. We had been pointing to the strength of the employment environment as a pillar of the economy that would determine whether a soft landing or a recession would follow. The Minneapolis Fed recently released an analysis that suggests that technology has changed the relationship between job openings and unemployment. In short, the ease of posting jobs may lead to a relative overstatement of the number of open positions as compared to historical experience. Available jobs are likely more in line with the number of job seekers. Inside the recent job numbers, away from leisure and hospitality jobs, an overwhelming percent of the jobs gained have been in the areas of local government, state government, and health services & social assistance. If we are heading toward a recession, the recent gains may be in sectors which offer very stable jobs, and recently several states and public entities gave workers raises of between seven percent and nine percent. In some areas public entity jobs are particularly attractive as compared to the private sector. At the San Fransisco Federal Home Loan Bank, average compensation and benefit expense per employee is $310,000 per year, which is on par with Goldman Sachs. At a higher level, some signs of cracks in the employment pillar are emerging. The Quits Rate has been in the 2.3% range, down from the peak of 3% in April of 2022. The ratio of unemployed people to available positions has fallen to 1.3X, the lowest level since mid-2021, and dramatically lower than the peak of 2.0X we saw in 2022. Worker Adjustment and Retraining Notices (WARN notices), which tend to lead layoffs by 60 to 90 days suggest that layoffs will pick up in 2024. Although the services sector of the U.S. economy has been soft since the middle of 2022, the more significant services part of the economy as measured by the ISM Non-Manufacturing Index is unexpectedly nearing contraction. In December the index took a significant dive to a reading of 50.6, remember a number below 50 suggests contraction. As it relates to the job environment, a subset of the ISM Non-Manufacturing Index, the Services Employment Index fell more than seven percentage points to a value of 43.3, the lowest reading since July 2020. The manufacturing sector has been slow, if we lose the strength of the service sector, it seems the sentiment of the market will rapidly move from a near certain soft landing to some degree of recession. Against that backdrop, the job market pillar of the economy could crumble. We look for the erosion to start in the first quarter and the negative feedback loop of economic pessimism translating into dampened business expectations, leading to job losses, have the greatest chance of coming to a crescendo late in the year.
"Recent events in the world should offer clarity that a lack of fighting shouldn’t be mistaken for progress toward peace."
Going back to the most frequent (post-1990) reasons for Fed action, global growth concerns and credit market issues were at the top of the list. As we look at global growth and risks to global growth, the headwinds are significant. In early January, the World Bank stated that the global economy is on track for the “worst half decade of growth in 30 years” and is expected to slow for the third year in a row, dropping to 2.4% in 2024 (down from 2.6% last year). To change course, they said “developing economies need to implement comprehensive policy packages to improve fiscal and monetary frameworks, expand cross-border trade and financial flows, improve the investment climate, and strengthen the quality of financial institutions.” Between China’s real estate and related financial institution challenges along with the profligate deficits and mounting debt in the U.S, it would seem the World Bank believes the world’s largest economies need to manage their imbalances. Depending on how the numerous sources of geo-political tensions play out, that may not be realistic in the context of the times in which we find ourselves. Taiwan’s January 13th elections, in the context of U.S. leadership in a state of flux as the year progresses, offers risks that could throw the world into turmoil. President Xi has recently said that reunification will occur. China has a demographic time-bomb facing them and as the U.S. is distracted by several conflicts, along with diminished will to fund significant portions of the military disputes, we seem to be at a tenuous time of opportunity for China and their reunification wishes. An invasion of Taiwan is expected to shave 10% off of global GDP. A more palatable blockade of Taiwan may reduce global GDP by 5% which is roughly the same amount of GDP shrinkage as caused by the Great Financial Crisis, or the Covid pandemic. The disruption to the global supply chain, particularly semiconductor chips, would completely disrupt manufacturing. Although domestic GDP would plummet and deficits would become massive, it is a dispute the U.S. would be forced to face with partners and allies. Recent events in the world should offer clarity that a lack of fighting shouldn’t be mistaken for progress toward peace. The mere increase in the threat of another conflict in the world seems to have solidified that deglobalization is hardwired into the base case for longer-term global economic activity. It should result in inflationary pressure and act as a drag on the global standard of living, a reversal of the influence China offered on global growth in the 1990s and 2000s, where growth was strong, and inflation was subdued.
Ignoring the impact that some version of WWIII may have (hopefully, exaggerating for effect) on Fed policy, a more likely dampener on the economy has to do with liquidity, access to credit, and perhaps spreads on lower-rated corporate bonds. As the Fed continues QT it will result in reserves leaving the banking system. Complicating matters a bit is the Fed’s Reverse Repurchase Agreement Facility (RRP) which has attracted up to $1.5 trillion in money market mutual fund (MMF) assets as temporary Treasury bill issuance declined during the debt ceiling crisis and the recent experience where yields offered by the RRP exceeded those provided by Treasury Bills. Short Treasury bills eventually saw increased issuance and the yields rose above those offered by the RRP, triggering roughly $1 trillion in MMF assets leaving the RRP since the peak in 2023. As MMF balances in the RRP move toward zero, the continuation of the Fed’s QT policy will drain bank reserves from the system. If the pace of QT continues for approximately two years, bank reserves may approach ten percent of GDP, nearing a point where the excess bank reserves converge toward zero. Bank loan officers are currently more conservative than they have been for most of the past 15 years, once there is a constraint on bank reserves, credit (the lubricant for the economy) may freeze. A recession may cause this credit contraction to serve as a start to a broader contagion that will spread to broader measures of credit, such as the access to capital and the cost of issuing debt in the corporate bond market.
"Taking the medicine now will be far better than the amputations that will be required in the future."
Although a restrictive Fed and softening economic developments should result in lower yields, a normalization of the shape of the yield curve and the expected future U.S. deficits, mounting debt burden, underfunded entitlement programs, and increased cost to finance the debt should create a long-term upward pressure on interest rates. Last quarter we offered an excruciating examination of the term premium and the natural level of interest rates (r*) needed to fund the debt, especially in the context of a QT world. This quarter we will simply offer the idea that the trajectory of our fiscal situation will have consequences. Taking the medicine now will be far better than the amputations that will be required in the future. Looking at the debt-related struggles of some the world’s frontier countries may offer a window into the future. That is not to say the experience in the U.S. will be of the same magnitude, or as imminent as the world’s poorest countries, but studying the extreme states of any situation is often useful. The debt of the 42 countries classified as frontier countries reached $3.5 trillion in 2023, double of what it was a decade ago. To stay solvent, many of these countries are having to dramatically cut budgets, as debt payments consume their budgets. According to the United Nations, about half the world’s population is living in countries that spend more on debt service payments than they do on education and health care. Citizens of some of these countries are growing impatient with the austerity needed to keep up with their interest payments, which has resulted in political upheaval. As the situation becomes more dire, credit being extended to these nations is drying up. Unlike the U.S. (currently), they can’t ease their burden through printing money and inflating their way out of the problem. To offer a couple examples of what too much debt looks like, Nigeria’s 2022 debt payments totaling roughly $7.5 billion exceeded its total revenue by $900 million and Pakistan spends eight times as much on its interest payments as it does on health care where the government can’t afford ambulances. The solution that is forced upon these countries is some form of reducing spending, raising tax revenue, or default. All the potential ways to address our domestic fiscal problems involve consequences but the challenge is that the near termism of our political structure is a mismatch for the long-term nature of the mounting problems we face. The U.S. should heed the World Bank’s advice and get our fiscal house in order, while the scope of our solutions involves band-aids rather than the loss of limbs.
Nearly every historically reliable predictive recession indicator is flashing red. Manufacturing has been slow, and the service side of the economy is nearing a neutral state. If we lose the support of the service economy, it should only be a matter of time before the volatile and fragile consumer sentiment will turn negative and a downward cascade of the job market will lead to a deteriorating feedback loop. Sticky sources of inflation continue to persist. In the past we have agreed with the idea that the last mile of the inflation fight will be slow and difficult for the Fed to achieve. We would like to revisit that position as our observation that markets tend to move in a regime switching way. It suggest that once the market is given enough negative data, the herd will change from the mindset that the Fed will be able to cut rates by 150 basis points in 2024 (to move toward a historically neutral nominal Fed Funds Rate) to a new view that “this tone deaf Fed is still so restrictive that they need to cut rates by at least 150 basis points, or more, to keep us from a deep recession.” Being a presidential election year, the Fed has a difficult job if it wants to implement surgical easing, balanced with their primary goal of tamping-down inflation expectations, while also not appearing to influence the results of the election. We think the path for rates is that the Fed will make its first cut late in the second quarter. They will be data dependent and we expect that will largely be driven by the state of the job market, evidence that growth is weakening and the level of real rates. Late in 2024 we think an increased expectation of a recession will develop as growth subsides and rates will fall, with a good likelihood that the yield curve resumes a normal upward sloping shape and the reduction in yields focused on the short part of the yield curve where short rates will fall more than long maturity Treasuries. A divided government should result in a mild but longer than expected recession, followed by a slower progression to the fiscal challenges addressed earlier. A scenario that would put that forecast at risk would be if a surprise candidate emerges that causes a “wave” election and single party rule, it would increase the chances of more fiscal spending, which would make a recession shorter and shallower and the probability of the more dire future solutions to our fiscal imbalance increases dramatically. Since history often rhymes, as can presidential candidates, the election may harken back to the choices of the Great Financial Crisis, stimulus, or austerity.
Summary
The game is tied up. It’s the top of the 9th inning and you have not so much as shifted your weight in your seat, let alone stood up and stretched. That is what we think 2024 will feel like. Be prepared to be uncomfortable. Global growth is expected to be slow while geopolitical tinder is widespread. The Fed will allow real yields to increase. The market will become more vocal about the Fed’s inaction. Meanwhile, they will be slowly achieving their goal of ending inflation. A recession should ensue and that may simply be the cost of the pandemic response excess. Normalized deficits approaching $2 trillion will have consequences. Our best guess is that the electorate will choose higher taxes for a segment of the population. It may be appropriate, but the cost may be diminished future economic growth. On a longer-term basis, structural deficits, and the cost to finance the debt may result in a higher neutral rate, higher real rates, and higher nominal rates than we have experienced for many years. The hard choices that the frontier countries must make now have a direct relationship to the choices we will be faced with in the future. The right answer for most people may be a blend of stimulus/support with a significant dose of austerity. The November elections may be a choice of the brand of medicine we want as compared to the cure we need, or it could be the sideshow we have come to accept/expect.
Owning long duration bonds has historically been a good strategy at the end of a Fed tightening cycle. Short term yields are somewhat average from a long-term vantage point but are attractive as compared to much of the last 15 years. We continue to like a “barbell” strategy with some short exposure and some longer exposure (depending on the specific mandate of a particular portfolio). The yield on shorter bonds is likely to decline, but for very little risk you are currently earning a nice return. Risk spreads are tight by historical standards and depending on the depth of a recession they offer potential headwinds to returns in some corners of the bond market. We would urge a quality bias in portfolios as spread movements could erode returns in 2024 or 2025. If the recession is mild and short, spreads could be essentially static. The metrics to watch this year will be the pace of the erosion of the job market and real rates. A wave election represents the most likely “known unknown” that would significantly change our bias and market assumptions.
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