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Weekly Market Analysis - US Interest Rates and the “New Normal”
Posted on3 Things to Know
Investors Shouldn’t Worry About Timing Fed Cuts
Fed Chairman Powell last week counseled for patience as the Fed’s preferred inflation measure continues to slow even while remaining above the long-term target of 2%.
If US employment growth remains on a slowing trend, we see the Fed being able to reverse a portion of its large tightening steps of the past two years, with the first steps taken this year. If we are wrong and the Fed cuts rates later than we expect, the exact timing shouldn’t matter much for most asset prices.
The Real Concern Remains Bond Yields
We believe the post-pandemic inflation surge jarred the world out of complacency about inflation risk. While the Fed has largely succeeded in shutting down any lasting rise in inflation expectations, there is greater risk premia in real bond yields.
FI Asset Allocation: Greatest Value in Intermediate-Duration Bonds
For the fixed income portion of an average investor’s asset allocation, we see the greatest value in high-grade intermediate-duration bonds. Across a range of bond segments, average yields are near 6.0% for 4-5 years. This is much higher than the Fed’s estimate of its “longer-run” normal policy rate (2.6%).
Summary
Where inflation and interest rates settle is a critical question for investors. In our view, the number of Fed rate cuts in the shrinking 2024 calendar is not where concerns should lie. History shows the lurch to judgement on US rates is often inaccurate and expectations unstable.
The most relevant questions for investors are:
- Under what economic conditions will US monetary policy ease, if at all?
- Where are interest rates really headed?
Long-term bond yields, the broad cost of debt capital, and exchange rates globally will be set by the answer to the
latter question. Monetary policy tightening, COVID-era supply constraints easing, and moderation of wild demand swings are all contributing to a gradual slowing in inflation (see chart). In our view, in a future recession of historic average magnitude, the US policy rate could fall to 2% rather than 0%.
Portfolio considerations
The real Fed Funds rate is currently 2.6 percentage points above the Fed’s preferred core inflation measure. This is above the 2.3 percent that prevailed from 1994-2007 (a period of strong underlying growth) and the 0.6% the Fed sees as “longer-term normal” now. Even if bond prices don’t surge, current yields are providing a much higher and more predictable source of return. Reinvesting fixed income proceeds as they mature can be expected to deliver a more durable flow of consistent income in the future.
Source: Haver Analytics and the International Monetary Fund, April 29, 2024. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees, or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events.
Investors Shouldn’t Worry About Timing Fed Cuts
The Fed concluded early in 2024 that it could unwind a portion of its extreme monetary policy tightening actions and help achieve an uninterrupted economic expansion during the next two and a half years. Such predictions can’t properly account for any unknowable shocks that might interrupt the economy. But we wholeheartedly agree with the Fed’s basic premise. As mentioned, monetary policy tightening, COVID-era supply constraints easing, and moderation of wild demand swings are all contributing to a gradual slowing in inflation. The very similar rise and fall in inflation across the globe points to common, severe, but mostly temporary factors. As we discussed in our April Quadrant, there seems to be much less divergence between US and European inflation readings than meets the eye.
Of course, if demand in the US were to persistently outstrip supply for goods and services, the Fed could be forced to hold to a restrictive monetary policy for longer or even resume tightening. As a base case, however, we continue to believe the Fed will be able to begin partially unwinding the sharp tightening steps that culminated in a 5.5% Fed Funds rate later this year.
The Real Concern Remains Bonds Yields
More important than short-term views is what to expect from the average US policy rate in the years to come. This “neutral” rate is the rate generally consistent with economic stability. We believe the Fed Funds rate will be closer to norms from before the Global Financial Crisis (GFC) of 2008/2009, rather than the ultra-low period that followed, particularly the “zero” of 2021 and negative nominal yields of some other developed market central banks.
“Normal” is neither the historical aberration of 1980 (double digit interest rates after a decade of accelerating inflation) nor 2020 (zero or negative policy rates). It’s a rate that should “average in” periods of recession (and early recovery) when the Fed is unusually accommodative. The Fed now estimates this “longer run” average rate at 2.6%.
In our view, in a future recession of historic average magnitude, the US policy rate could fall to 2% rather than 0%. Many investors anchor expectations to the two most recent recessions – a pandemic and an intense banking crisis – which were particularly severe and required unconventional government stimulus. With rates less likely to fall to 0%, in the next recession, the longer-run average interest rate could be at least 3.0%. This points to long-term US Treasury yields having reasonable value above 4.0%. However, the actual rate will vary from this and perhaps for a significant period of time.
FI Asset Allocation: Greatest Value in Intermediate-Duration Bonds
While yield levels may not drop quickly and offer a large “snap higher” in bond prices, current income is higher and we expect reinvesting fixed income proceeds will deliver a stronger and more consistent income in the future. We continue to advocate maintaining duration around 4-5 years for overall fixed income portfolios. US Investment Grade (IG) credit spreads remain very tight, about 80 basis points currently. While this spread is low, it is still incremental yield in addition to Treasury yields, and thus provides some additional income for core fixed income holdings.
We also suggest that suitable clients should consider low BBB-rated and BB (high yield) corporate bonds, where one can potentially earn additional spread over the intermediate IG corporate index. We are also particularly constructive on “structured credit” for suitable and qualified investors. This includes Agency AAA-rated mortgage-backed securities (MBS) which are currently offering yields in excess of the corporate IG index.
Finally, suitable investors may want to consider an allocation to IG preferred securities. Yields for these IG securities are currently slightly higher than the BB-rated high yield index. Additionally, depending on structure, many of the US-based preferred issues’ interest distributions are taxed as dividend income, which can have a preferential tax rate for certain US taxpayers, and so potentially increases the pre-tax equivalent yield.
