The Federal Reserve was adamant about reversing their series of rate hikes last December, only to be forced to back-track when economic growth reignited in the first quarter. When growth reaccelerated, there were even calls, albeit muted, that the Fed would need to raise interest rates at least one more time. Through the second quarter, the talk of another rate hike has been quelled by a resumption in the fall of inflation and a cooling in the job market.
The May employment report, released earlier this month, fully took the air out of the notion that the Fed would cut interest rates in the near term. After April’s report came in below expectation, economists were expecting the number of new jobs created for the month would total 180,000, with the low estimate at 120,000 and the high at 259,000. The actual number blew past those forecasts with 272,000 new jobs created in the month. The report was a little messy in that the household report showed a contraction of 408,000 jobs and the labor force shrunk by 250,000 workers causing the unemployment rate to tick up to 4.0%. We advise to look past that uptick due to a few nuances between the household and the establishment survey. The bottom line is the June jobs report changes the soft-landing narrative and further postpones the likelihood of a rate cut anytime soon.
This month kicked off with the conclusion of the FOMC meeting. It was widely expected that Chairman Powell would acknowledge that the Fed made a mistake in suggesting that rate cuts were imminent back in December. He didn’t go quite that far but did opine that the committee was “less confident” that inflation would fall to 2% in the near term. But he also cast doubt on the possibility that the next move in interest rates would be a hike, as has been suggested by market watchers.
March rounded out a quarter in which the equity market was cheered by the prospect of lower interest rates despite rising rates across the yield curve. Members of the open market committee, the arbiters of interest rate policy, continue to espouse three rate hikes this year despite continued solid economic growth. Given that backdrop, it appears that Chairman Powell and his fellow committee members are as wrong on their interest rate forecast as they were when they tried to calm concerns when inflation first appeared three years ago. The calming words that inflation would prove “transient” quickly devolved into the worse inflationary impulse in decades. Then at the December 2023 FOMC meeting the committee forecast that the rate rising cycle was not only over but expected to reverse much of the rate rise over the coming two years, with the first rate cut coming in March 2024.
One must wonder if the Federal Reserve is deliberately trying to mislead fixed income managers. It certainly seems that way. In 2022, when inflation warning signs were flashing everywhere, the committee maintained their expansionary, zero percent interest rate policy. Their response to the alarming pace of inflation was that it would prove transitory, and that inflation would soon return to the sub-2% trend. The fixed income community, believing the Fed possessed superior knowledge, extended duration to lock in the higher interest rates of the then upwardly sloping yield curve. After months of insisting that that the rise in inflation was transitory, the Committee realized that they had been wrong, and inflation was becoming entrenched in the minds of consumers. Upon that realization, the committee reacted by raising the overnight interest rate 500 basis points over the subsequent 16 months, causing the economy to wobble, and grinding the housing market to a near halt. That sharp move higher in the overnight rate pulled the entire yield curve higher as well, resulting in sharp losses to intermediate fixed income investors.
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.