January 2025

Since the first of January, fixed income portfolio managers have been tasked with the challenge of how to position their portfolios for the coming year.  The Summary of Economic Projections (SEP) issued by the Federal Reserve members in September were out of date almost immediately, as economic growth reaccelerated. Concurrent with that reacceleration, the stock market roared higher at the prospect of President Trump rolling back business-hampering regulation and enacting pro-growth policies. By the December FOMC meeting the Federal Reserve was tacitly signaling their error. With that change, market participants are now expecting a 25-basis point cut by this summer and a 50% chance of another 25 basis-point cut by the end of this year.

The conundrum managers face is handicapping what policies the President will successfully enact and how they will affect economic growth and inflation.  Since being sworn into office last month, Trump has demonstrated a willingness to act quickly and ignore the consequences. A significant leg of his platform is the gapping trade deficit between the United States and the rest of the world.  Judging by his rhetoric, his goal is to have our trading partners buy as much American-made goods from the U.S. as the U.S. buys from them.  In its simplest form that sounds entirely reasonable.  However, getting to that balance could prove painful for the U.S. consumer.  Applying a tariff to an imported good will cause the price of that good to rise, which will be captured in the inflation indices.  The Fed watches those inflation measures closely and any uptick is likely to force them to restrict monetary policy via raising the overnight interest rate.  In that instance, the sensible course of action would be to reduce portfolio sensitivity by shortening the average maturity of the portfolio.  On the other hand, if inflation rises to a level where consumers are forced to cut back on purchases and economic growth stalls, the Fed could be forced to ease monetary policy by lowering interest rates.  In that instance, the fixed income manager would want to increase the average maturity of the portfolio to lock in the higher interest rate before the FOMC is forced to cut rates.

Further complicating the decision, the newly named Treasury Secretary, Scott Bessent, said that he and the President are both in agreement that they would like to see interest rates lower, but he specifically identified the 10-year Treasury note as being the rate he would like to see targeted.

Wanting the 10-year to fall is understandable, as mortgage rates and corporate borrowing are priced off that maturity.  Having that rate lower would go a long way to reviving the moribund housing market and, in turn, the economic multiplier that it represents.

Bessent suggested two potential courses of action to get that rate to fall; the first is to reduce the weighted average maturity of the outstanding Treasury debt by issuing more short-term maturities, the second was the possibility of buying outstanding longer maturity debt in the secondary market.  As Treasury Secretary he has the authority, and likely the backing of Trump, to accomplish the first alternative.  The second option would require cooperation with the Federal Reserve, which is likely to be reluctant to again expand their balance sheet.

Regardless of which course of action Bessent decides to pursue, the duration management decision becomes a complicated one as it comes down to the question of is the Fed going to continue to pursue their hawkish tilt on inflation or is the Treasury Department is going to tinker with the maturity structure of outstanding debt.

Regardless of the path forward, we expect heightened volatility in the bond market until there is more clarity.

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