With February upon us it may seem odd to revisit the December open market meeting, but the January employment report and the recent 60 Minutes interview of Chairman Powell has us wondering, “what were they thinking?” What we refer to was the dot-plot indicating three rate cuts this year. We’ve never been in favor of the Fed publicly forecasting their expected course of action and this is exactly why. After leaving the overnight rate unchanged for two consecutive meetings, bond investors assumed by their lack of action that they were probably done with the rate hikes. But rate cuts weren’t really on anyone’s radar. Speculation started to creep into the market in November as managers anticipated that we had reached the peak in rates, but the Fed’s communication caused a sharp drop in interest rates across the yield curve. That narrative unleashed a torrent of buying that sent the 5-year note from just a shade under 5% all the way down to 3.8%.
As the new year kicks off, the bond and stock markets seem to be expecting different outcomes this year. The bond market closed 2023 with a torrid rally that took the yield on the five-year note to 3.8%, down significantly from the mid-October high of nearly 5%. Similarly, stocks, as measured by the S&P 500 closed the year less than 1% away from an all-time high. Seemingly, bond investors view the economy as being on the precipice of, if not already in, a recession; while equity investors seem to be anticipating that profitability is about to reaccelerate. The obvious culprit for the divergence in views is the Federal Reserve’s about-face on interest rates. Prior to the December FOMC meeting, the Fed’s monetary policy had been communicated as “higher for longer” indicating that they were in no hurry to cut interest rates as inflation drifted back to their stated target of 2%.
As we close out the year, investors seem to have concluded that the Federal Reserve has mostly accomplished their mission of containing inflation while simultaneously achieving an economic soft landing. We agree with the consensus. Year-over-year, the consumer price index was 3.1% in November, and we think that getting back to the Fed’s target of 2.0% will prove elusive for a few reasons. Principally, the changing workforce. The workforce is shrinking as the baby-boomers age out, and as it shrinks workers are finding they hold wage bargaining power, as evident by recent union gains and the rising minimum wages. To maintain profit margins, companies are forced to raise prices which creates the dreaded wage-price spiral. The Fed had hoped to avoid the occurrence by slowing the economy, but structural forces have prevented any slowing to date. Instead, the Fed is likely to need to raise their inflation speed limit to 3%.
The short maturity fixed income market is the most attractive that it’s been in years, though there are skeptics warning that rates could go higher still. We’ll craft the following paragraphs to argue why it’s an attractive time to take advantage of the current interest rate environment.
One argument against fixed income is that the intermediate fixed income index is at risk for its third consecutive year of losses. To be clear, we are not talking about intermediate fixed income. At Halyard Asset Management, we manage a short maturity fixed income product called Taxable Reserve Cash Management (RCM) that has a maximum maturity of 2 years for fixed rate securities and a targeted average maturity of approximately 13 months for the portfolio. Securities held include a mix of Treasury notes, Treasury bills, and corporate bonds, and a weighted average yield-to-maturity of 5.85%, as of 10/31/23. Since the 2010 inception of Halyard, the RCM has not had a one year in which the performance was negative! In the 157 months it’s been managed, only 26 months had a negative sign next to the result. That’s an 83%-win rate. Of course, past performance cannot guarantee future success. With that in mind let’s tackle some of the other arguments why one should avoid fixed income.
The minutes of the September 19-20 FOMC seemed to reflect the committee members’ belief that they’re in the process of achieving the first ever economic “soft-landing.” Comments from the minutes included “Bank credit conditions appeared to tighten somewhat…but credit to businesses and households remained generally accessible,” and “The imbalance between labor supply and demand appeared to be easing.” As expected, the text echoed the answers delivered by Chairman Powell at the post-meeting press conference. There is a chance of one more rate hike this year and that rates will be held at an elevated level for an extended period. In short it read as though the committee was taking a victory lap for their engineering of a soft landing. Bond investors were delighted by the verbiage as witnessed in the collapse of the yield curve. The yield on the 10-year note fell to 4.55% on the day.
As expected, consumer prices rose in August, rising more than consensus expectation. The year-over-year measure of CPI registered 3.7%, up from 3.2% last month, but the core CPI for the same period fell from 4.7% to 4.3%. That’s far from the Fed’s 2% target but the anecdotal slowing in the economy is likely enough to keep the Fed on the sidelines at the September 20th FOMC meeting, but not enough call the current monetary policy the peak.
There’s a lively debate between those that believe that economic growth is slowing and those that believe it’s reaccelerating. The actual outcome will have a marked impact on the progress made to date on inflation. Clearly, employment growth has slowed from the torrid pace witnessed earlier this year. The July nonfarm payroll report registered the first back-to-back sub-200,000 growth since December 2020. Similarly, the jobs availability measure (JOLTS) has contracted to less than 10 million from the 12 million touched earlier this year. But with 9.5 million unfilled jobs still available it seems unlikely that the economy is on the verge of a significant stumble. On the other hand, retail sales for July paint a picture of a confident consumer seemingly unworried about income and willing to spend. That creates a conundrum for economists. Clearly certain industries, namely housing and autos, have slowed down or are in outright recession, but that has failed to impact consumption.
The June payroll gain was the slowest in 30 months, coming in at 209,000 new jobs versus the 230,000 consensus expectation. That disappointment was offset by a greater than expected jump in average hourly wages. The wage measure came in at a 4.4% annualized rate versus the 4.2% expectation. The unemployment rate ticked down to 3.6%. A loosely interpreted rule of thumb is that the economy will continue to grow when more than 200,000 jobs are added per month. The BLS report was especially disappointing when compared to the private ADP jobs measure released on Thursday that showed a whopping gain of 497,000 new jobs. As we have cautioned in the past, seasonal adjustments applied to the BLS measure cause the two reports to deviate from time to time. Also of note, the revision to the previous two months was 110,000 jobs lower.
The Fed paused! Following ten consecutive rate hikes, the FOMC refrained from raising the federal funds rate at the June meeting. The summary of economic projections of the committee members offers some insight into their thinking. Despite leaving the overnight rate unchanged, the committee raised its Fed Fund forecast for the end of this year to 5.4% – 5.6%, an indication that they believe additional hikes will be warranted. What likely drove that decision was the lowered forecast for the unemployment rate from 4.5% to 4.1% and the forecast for real GDP revised for this year from 0.4% up to 1.0%.
With volatility still at a heightened level from the failure of Silicon Valley Bank, Signature Bank, and First Republic, we thought it would be an opportune time to discuss how we’ve positioned our Reserve Cash Management strategy (RCM). As the name implies, the RCM is a separately managed account strategy designed to generate returns in excess of the money market universe with a somewhat similar risk profile.
The short-maturity fixed income landscape is vastly different than last year. Namely, the overnight lending rate corridor is 5.0% to 5.25% and we’re likely at the peak of that rate for this cycle. Moreover, the Fed Funds futures market is anticipating that the Fed will cut the overnight rate later this year and will ultimately take the Fed Funds rate below 3.00%.