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Written by: JB Golden | Advisor Asset Management
The Federal Reserve seemed to indicate at the December 13, 2023, Federal Open Market Committee (FOMC) meeting that they were done hiking the Fed Funds rate. The meeting included an updated Summary of Economic Projections — euphemistically known as the “Dot Plot” — that reflected FOMC expectations for Fed Funds to be approximately 4.6% by the end of 2024. This would be roughly 100 basis points lower than current levels and represent three to four rates cuts in 2024. Federal Reserve Chair Jerome Powell’s post-meeting press conference, on the heels of the December meeting, was hailed by many as uber-dovish, and the market began the process of pricing in expectations for the path of monetary policy in 2024. By the end of 2023, U.S. Fed Funds futures implied almost seven rate cuts by the end of 2024 with an implied 2024 year-end Fed Funds rate of 3.75%.
The use of Fed Funds futures to imply market expectations for Fed policy is historically noisy and volatile but suffice to say markets priced in a much more aggressive path down than telegraphed by the Federal Reserve at the December meeting. The end of rate hikes seemed again to be confirmed by the Federal Reserve at last week’s meeting on January 31. Powell explicitly acknowledged that the Fed was likely done with rate hikes. In addition, there were numerous edits to the Fed’s January statement with the most important change likely the removal of any language that described the Fed’s bias toward tightening policy. Language in the new statement now speaks to a neutral stance. The edits and change in tone seem to be a clear signal the Fed has moved into a new stage of monetary policy. However, the FOMC also pushed back against the aggressive path priced into markets. Both the January statement and comments from Powell at the post-meeting press conference questioned the notion that cuts were looming over the horizon without more confirmation inflation will continue to move toward the Fed’s target. To start February, market expectations for future Fed action have moderated. Odds for a hike as early as March have fallen significantly, but markets are still pricing in almost six cuts by the end of the year and a 2024 year-end Fed Funds rate of 3.8% — which seems at odds with the messaging from the FOMC meeting. It seems the days of Fed-induced volatility might not be in the rearview mirror, but this time around does it matter? One could argue that while the Fed still faces some tough decisions, any path forward from here could potentially be a win-win for bond holders.
The rate debate seems to no longer include concerns the Federal Reserve will need to continue to hike rates to contain inflation. With the last two Fed meetings in the books and a clear change in language and messaging the debate has moved from how high the Fed will go to whether they will have to hold “higher for longer” or whether a pivot to rate cuts in short order is in store. Either of those scenarios are better than higher rates as it relates to the bond markets. In the event the Fed does have to hold rates “higher for longer,” it likely would not include the neck-snapping volatility to the upside that we have seen in recent years and clears the slate for the coupon income to do the heavy lifting. Bond yields are still near highs of the last 15 years meaning the expected return on these instruments, assuming no impact from rates, also could be near 15-year highs. On the other hand, if the Fed does pivot to cuts in short order, bonds should benefit. This likely would not hold for many areas of the bond market where lower rates are driven by risk aversion which could lead to wider credit spreads. Regardless of which path comes to fruition, the outlook for bonds improves with the expectation rates hikes are over.
That said, the economic backdrop makes it tough to have much conviction in a scenario where 2024 includes the Fed cutting rates six times! If the Fed does, in fact, cut rates six times this year it likely will be because the “variable and lagged” impacts of higher rates have broken something in the economy. The recent resumption of regional banking concerns comes to mind. The underlying strength of the economy, along with inflation that is still higher than target, doesn’t seem to be a set of circumstances that justifies such an aggressive path of cuts. Furthermore, a strong economic backdrop gives the Fed cover to hold rates steady. The Atlanta Federal Reserve GDPNow model currently projects Q1 (first quarter) 2024 GDP at a whopping 4.2%. The labor market remains robust with a huge beat on payrolls last Friday, including upward revisions to previous monthly figures and a beat on wage gains. Recent manufacturing data is showing marked improvement.
Consumer confidence is beginning to improve and retail sales and personal spending, defying the expectations of many, remain strong. Perhaps most importantly inflation remains elevated. Powell acknowledged the economy is too strong to justify aggressive cuts in comments last Wednesday afternoon saying, “We’re not really at that stage, there was no proposal to cut rates. We weren’t actively considering moving the Fed Funds rate down.” Furthermore, the Powell went on to say that they needed further evidence, likely to include slower economic growth, that inflation was, in fact, contained before considering any rate cuts. Regardless of how monetary policy evolves over the course of the next year, most bond holders can take solace that the most likely paths have the potential to bode well for bonds. To end, however, this comes with a caveat. There remains a risk that the Fed cuts rates not because inflation is contained, but because the economy weakens, or serious developments dictate action. With credit spreads in the riskiest areas of the bond market still well under long-term historical averages, this could spell trouble for bonds with more credit risk. While the last couple of months would tend to indicate that interest rate risk is abating, this cannot be said for credit risk; quite the opposite as recent economic strength supports tighter spreads. Without further clarity on whether the economy can nail the “soft landing,” we believe it might be worth considering an upward bias in credit quality.
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