February 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.

Despite that tightening of policy, the economy currently seems to have defied conventional wisdom and achieved a soft-landing with low unemployment and a gradually falling inflation rate.  Inflation is not back to the Fed’s 2% target rate but has moved in the right direction.  With the soft-landing in sight, the Fed at their December 2023 meeting released their interest rate forecast for 2024 which reflected the expectation of three rate cuts in the new year and the suggestion that the first cut would come in March 2024.

Fixed income investors appreciated the heads up and extended the duration of their portfolios in advance of what they deemed to be falling interest rates.  The consensus among fixed-income professionals was that the Fed would commence lowering interest rates aggressively over the course of the coming 24 months.

Instead, with the first two months of the year behind us, economic data has been relatively strong with inflation ticking up and the unemployment rate falling.  Lowering interest rates stimulates the economy and that’s exactly what the Fed shouldn’t want to do when the economy is healthy, and inflation is drifting higher.

By late January, as economic data began to reaccelerate, Chairman Powell tried to walk back the idea of a rate cut in March, but not the idea of three rate cuts this year.  As a result, those portfolio managers that believed the Fed in the direction of interest rates suffered losses.  For February, the 2-year note is 0.41% higher in yield and the 10-year Treasury yield is 0.34% higher.  The move translated into approximately a 1.4% loss for the Bloomberg U.S. Aggregate Index, which most intermediate fixed income mangers model their portfolios. Despite the sharp market correction, and portfolio losses incurred, Fed officials continue to suggest that three rate cuts are likely this year.

The problem for many of those managers is that they underperformed that index because the Federal Reserve led them to believe that they were on the verge of an extended rate-cutting cycle.

From our perspective, the Fed committee members have woefully failed at their ability to forecast and should permanently end the practice.

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