Macro Markets Podcast Episode 47: Investing as the Fed Prepares to Start Rate Cuts
Evan Serdensky, Portfolio Manager on our Total Return team, and Matt Bush, our U.S. Economist, join Macro Markets to discuss the latest FOMC meeting and the January jobs report and provide an update on fixed-income portfolio positioning and our monetary policy outlook.
This transcript is computer-generated and may contain inaccuracies.
Jay Diamond: Hi, everybody, and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I’m Jay Diamond, Head of Thought Leadership for Guggenheim Investments, and I'll be hosting today. We are recording this episode on Friday, February 2nd, 2024. Now, it's been a busy couple of weeks of data to absorb for investors, culminating in this week's meeting of the Federal Open Market Committee and today's jobs data release. So, there's been a crosscurrent of market sentiment that has unsurprisingly led to a spike in bond market volatility. Well, here to help us find the signal through the noise are two of our investment team leaders, Evan Serdensky, a Managing Director and portfolio manager on our Total Return team, and Matt Bush, Guggenheim Investments’ U.S. Economist. Welcome back, Matt and Evan, and thanks for taking the time to chat with us today.
Evan Serdensky: Thank you for having us, Jay.
Jay Diamond: Today's jobs number was a bit of a shot across the bow for markets and an important data point for the Fed to be considering. So let's start with the Fed's organizational state of mind, if you will, and how they may have received this information. So, Matt, to start us off, tell us about this week's FOMC decision and what you heard in the press conference afterwards.
Matt Bush: Sure. So I think, big picture, this week's meeting confirmed we are shifting toward a rate cut cycle. The post-meeting statement removed the reference that previously had to future increases in the Fed funds rate and actually added a reference to future reductions in the funds rate. So, cuts are coming. The more surprising aspect of the meeting was the degree of caution, though, shown by the Fed in declaring victory over inflation. In the statement, they added they don't expect it will be appropriate to cut rates until they've gained greater confidence that inflation is moving sustainably toward 2 percent. Given that we've seen core PCE inflation below 2 percent for the past seven months now, we thought that they were well on their way to having enough confidence by the March meeting. But halfway through the press conference, Powell came out and said it was unlikely they would have enough confidence by March. So, it really just appears that they need a really high bar of evidence before they start bringing rates down, and that does push the timing of the first hike to May or possibly even June.
Jay Diamond: So how would you describe the Fed's posture in brief?
Matt Bush: I wouldn't call it either hawkish or dovish. I would just call it patient. They had this high bar for deciding inflation is coming down, but in their view, they can afford to wait. They're looking at good economic growth conditions, they're looking at the labor market holding up, they’re looking at signs of market stress easing and say all these factors don't really create any sense of urgency to start cutting rates before they're absolutely sure that inflation is going to stay down. So, it's really just a cautious and patient stance.
Jay Diamond: So just from a very high level, given what we're seeing in terms of relative strength of the economy, why would the Fed be considering cutting rates at all?
Matt Bush: That’s a good question, and one we're actually getting a lot. If everything is going well, why mess with it by changing rates? I think there's a couple of reasons, though. And first, as Powell said at this week's meeting, the Fed doesn't have an economic growth mandate, they have a mandate for stable prices and maximum employment. So, strong economic growth only matters if it affects those sides of the mandate. And usually, it does, but what we're seeing now is that growth is being driven by supply side expansion of the economy, which means we're adding more capacity and that allows for solid growth alongside inflation coming down. That's one reason, they're not directly focused on growth. Second is the argument you're increasingly hearing from various Fed speakers that as inflation comes down, if the Fed keeps nominal interest rates unchanged, the real rate of interest actually goes up, and in most economic models, it’s the real borrowing costs that matters to the economy. So, they want to avoid this passive tightening in the real rate by cutting rates as inflation falls. And then kind of a related idea is, the economy is holding up well, but a lot of the economic resilience we're seeing is due to businesses and financial markets looking ahead with expectations that rates are going to come down later this year. You see a lot of companies, a lot of industries really kind of hanging on, trying to make it through the other side where they'll get some rate relief. So, the Fed actually needs to deliver on these expected cuts if they want the economy to continue to hold up.
Jay Diamond: I heard some concept about something called a maintenance rate cut as opposed to a rate cut that's designed to help the economy restart. Is that what we're talking about?
Matt Bush: I think it's a little bit more than just a maintenance rate cut. I think that would refer to just one, two or three cuts. I think a lot of people heard the push back for a March cut by Powell and took it as very hawkish. In some ways it was, but at the same time, I think the high degree of caution indicated by Powell is because he seemed to indicate that once they start cutting, it's going to be the start of a somewhat prolonged process. So, they don't want to start that train rolling too soon, which actually is a little bit dovish. It means that they're not going to be cutting on a meeting-by-meeting basis. They're just doing a couple maintenance cuts. Once they start cutting, they expect to be cutting for a while, and so I think that's kind of the outlook that we should have.
Jay Diamond: You brought this up before, but given this strong caveat that was put out there regarding what it would take to move to lower rates, when do you think the Fed will begin and how long do you think it will last?
Matt Bush: Yeah, I think given Powell's direct pushback against March, you have to say now May is the base case with some risk that could even be pushed into June if there's an interruption in the good inflation data. But I think there's way too much focus on March versus May and when the first cut happens. Ultimately, what matters for most investors is that rate cuts are coming. As I said, Powell emphasized, is going to be the start of a prolonged rate cut cycle, and we think ultimately, by around the middle of 2025, we'll have the Fed funds rate a bit below 3 percent, which is not too far off from where the Fed thinks they will ultimately get. And so, whether it's March or May, I don't think that makes a huge degree of difference either to the economy or to markets, at least in the longer term. The bigger picture here is that we expect the Fed funds rate to come down significantly over the next year to year and a half.
Jay Diamond: Great. Now Evan, I referenced at the top the market response or anticipation of all this. How was the market behaving before the Fed meeting and what has happened since?
Evan Serdensky: Well, the rates market, in a word, has been erratic over the last several months. There's been some really dramatic moves. If you rewind to the third quarter of last year, yields were essentially steadily moving higher for a few reasons. One, pricing out of some of the risk premium from the regional bank crisis in March. The data was slowing, but not very fast, so people were expecting a potential soft landing scenario and then concerns over Treasury supply were building. And there was also some element of a just pure technical or psychological test of the 5 percent level across the curve, which is what Treasury curve reached at the end of October. And then as the calendar flipped to November, there was a big seasonal shift, which I think is one thing that might have been underestimated by a lot of people in terms of the technicals changing. And you also had some meaningful announcements from the Treasury in terms of the quarterly refunding announcement came in lower than expected, that helped push yields lower. And then on the monetary policy side, the November and December meetings, December in particular, was very dovish and so that helped to bring yields down from 5 percent to around 4 percent. So, a 100 basis point move, which is quite dramatic. During this time, risk assets were mimicking that move and essentially trading levered to rates, which was a theme that we were really focused on last year and gave us some comfort in owning credit risk despite a weakening macro picture because spreads were relatively wide at the time. So then if you fast forward to just before this meeting, as Matt just talked about, there were essentially six insurance or maintenance cuts priced in, which was more than the Fed was projecting of themselves in their dot plot. They had three priced in. And despite Chair Powell trying to come off as hawkish in terms of the path of monetary policy in this most recent meeting, I think the market reaction was very telling. Rates were basically unchanged, even slightly lower after the meeting. So, the markets telling the Fed that the data doesn't support how tight monetary policy is right now and they'll have to come down, and we generally agree with that.
Jay Diamond: So as a follow up, given the path that that Matt has sketched out and what you discussed, what do you see broadly happening in the market as events play out from here?
Evan Serdensky: I think the clearest message from Powell in this meeting was that the committee believes that they're at peak rates for this cycle, and therefore that firmly puts us in the pause phase of the monetary policy cycle. And so when you look at history, nearly all financial assets do well on a pause phase, both rates and risk, and that's exactly what we've seen happening. But as the cycle shifts more towards the easing phase, especially late in a cutting cycle, that's when you start to see risk assets diverge and rates, especially longer duration and higher quality, tend to outperform meaningfully in that phase. And so that kind of simple framework is our North Star right now and is really guiding our risk taking and our asset allocation strategy.
Jay Diamond: Okay. Now, Matt, we buried the lede a little bit on the podcast today, but let's dive a little bit deeper into the latest data releases. Of course, the GDP print, the latest inflation data and, of course, today's jobs report. What did you see there?
Matt Bush: Saw a lot. I mean, some of it is an important signal, but a lot of it is noise. So let me try to cut through some of that. We’ve seen in the economic data strong economic activity, we think is still a gradually cooling labor market, and then, of course, falling inflation. So on the GDP side, we had fourth quarter real GDP growth that was a bit flattered by a big inventory build. We tend to focus more on private domestic final demand, which is the most durable part of GDP and most relevant for things like corporate earnings. And that grew 2.6 percent in Q4, which is a solid rate, and 2.8 percent or the second half of 2023. So, a very solid run for economic activity. And importantly, on a forward-looking basis, the monthly profile of economic growth suggests that December was a lot stronger than earlier in the quarter. And this so-called handoff effect means that Q1 will likely see another solid quarter of economic growth. Turning to the jobs report, which is probably the most surprising of the recent data we've gotten, obviously the January numbers were a big surprise, higher than all 77 consensus forecasts that Bloomberg compiles, with a 353,000 gain last month. I do think there is a lot of noise in that number, though. January is always tricky because it has the largest seasonal adjustment factor of any month. January on a non-seasonally adjusted basis is a huge month for job loss, so the seasonally adjusted numbers are really about how much job loss occurred relative to normal, not about actual job gains. We also had a pretty low response rate to last month's survey, which just introduces more noise. And looking away from the headline payrolls number, we also saw the average amount of hours worked fall. So, if you look at total hours worked last month, it was actually lower than in December even with the strong jobs number. So, a lot of noise and caveats in the data. I think smoothing through that noise, the jobs data is telling us things are gradually cooling off, but there does seem to be some stabilization going on where some of the downside risks to the labor market that was looking really concerning at the end of last year, that downside risk has probably been reduced in part because employers are seeing a better economic outlook, they're expecting Fed rate cuts, and they're holding on to workers. And then on the inflation side of things, as I mentioned, we've seen seven months now of core PCE inflation below 2 percent on an annualized basis. So in that respect, we're already back to the Fed's target. And those low inflation readings are coming even with rental inflation numbers still elevated, which we know from the more timely measures of rent are going to come down and help keep inflation subdued. So, I think the way to reconcile all this data is that we're experiencing strong productivity growth. Workers are producing more per hour worked, that's helping GDP expand at a solid rate, even as the labor market cools off. And by creating additional capacity in the economy, it lets inflation cool down. So, it's a pretty economic sweet spot to be in right now.
Jay Diamond: So just to follow up, Matt. I know that we've been talking about a recession, but how does all this play into your outlook for a recession?
Matt Bush: We've marked down our recession probability, particularly for the near term. Given this resilient economic data, given the market is now firmly pricing in a rate cut cycle, that provides some near-term relief. But we don't think recession risk has been eliminated and certainly not as low as the very optimistic market consensus thinks. And that's really because when you get unemployment as low it is now, recession becomes much more likely, as there is just less available slack to draw down upon. If you just look statistically, when unemployment falls as low as it is, on a forward-looking basis recession risk is as good as a coin flip. And you even saw Powell admit this at the January press conference, he was saying that the supply side boost that we're seeing is very welcome, but it's not likely to last, and when that fades away, the monetary restraint will become much more apparent and really weigh on growth. So, you know, on a 3-to-6-month type horizon, we're less concerned than we were about a recession, but still think risk is elevated on a more 12-to-18-months type horizon.
Jay Diamond: So, Evan given what we've been discussing, do you believe that markets are going to be reflecting a period of greater uncertainty, or are we actually sketching out an intermediate term where things are coming into clearer focus and it's just a question of timing?
Evan Serdensky: Well, can it be both? The rates picture and the monetary policy path is arguably more clear now. The FOMC is really trying not to surprise markets and they spelled out pretty much exactly where they think we are in the cycle. But at the same time, there's plenty of uncertainty on the geopolitical front, of course, and those risks are notoriously difficult to price. And then other risks are how will the end of Q.T. play out? There's still liquidity draining from the system. And then of course, through cutting cycles, they rarely go off without fireworks. There's usually some sort of a risk flare up. And so, we're essentially expecting the unexpected at this point.
Jay Diamond: Well, let's talk about what I call the three pillars of credit in America: the federal government, the consumer, and corporations. Matt, are you seeing on a macro level for these pillars?
Matt Bush: On the government side, the key dynamic is we're coming off a huge expansion of the fiscal deficit that really helped support the economy in 2023. The deficit this year is likely to still be very large, but it's probably not going to get any bigger. So, in terms of an impact on economic growth, it's going to be pretty small for this year, which is one reason why we do think growth will cool off. But again, in level terms, the deficit is still very large. That creates fiscal pressures, it creates rate pressures, and probably limits the downside for interest rates. On the consumer side, looking at the aggregate numbers, things in terms of credit conditions still look fine. Debt service costs have barely risen over the last few years, even with much higher interest rates, but we're seeing growing bifurcation under the surface. You see it in rising delinquency rates for lower income borrowers who have largely run down their excess savings and are more reliant on credit. So, I think it's important when thinking about consumer health to look past just the headline figures and you see this growing gap between higher income, more well-off borrowers and then the lower income cohorts. And it's a similar story on the corporate side, more bifurcation, and it's really between large and small companies. Smaller companies have more refinancing to do this year into a high-rate environment. And at the same time, they're struggling with tighter access to credit as banks have become more cautious and are pulling back. Large companies, on the other hand, have large cash stockpiles. They're actually benefiting from high rates in some cases because they're earning high interest income and they have easier access to financial market-based credit where conditions have eased a lot. So again, a growing gap between the large and small companies. And I think one good illustration of this, divergences in the equity market, where the S&P 500 is about 3 percent above its 2021 highs, but the equal weight index is still 5 percent below and small caps are nearly 20 percent below their prior highs. So it shows that it is reflected in market performance, but if you just look at the aggregate cap-weighted numbers, you would think everything is fine.
Jay Diamond: Now, even on a micro level, what are you seeing in terms of credit fundamentals and performance?
Evan Serdensky: I think Matt summarized it pretty well. At the highest level, credit looks relatively healthy. You're seeing credit fundamentals plateauing and softening on the margin, but nothing really alarming. But then when you peel back the onion, you see that the largest subset of the categories, in fact, in that group that's doing fine, but you're seeing the tail start to diverge and thicken across quality spectrums. There's a small portion that's doing great. Those are the cash rich companies with pricing power diversification. They tend to be larger. But then the lower quality, and especially floating rate borrowers, are seeing their fundamentals weakening. They obviously got hit by inflation squeezing their margins and now interest costs. And so, in a word, bifurcation is what we're seeing at the individual company level.
Jay Diamond: Evan, we've seen spreads coming in across most fixed income sectors. When you're looking at the market, how do you balance spread against yield and looking at opportunities?
Evan Serdensky: So, I think a lot of the beta moves and spreads are behind us. At this point, a lot of spread valuations are in, call it the 20th percentile for liquid credit indices. But the investing environment is shifting much toward more towards relative value, so we're seeing greater idiosyncratic moves. There's plenty of single name and sector level volatility, and that's really great from our perspective. And this is all supported by a relatively high yield environment, and that's really important for the overall investing environment because it gives you a floor on your total return when a lot of it can come from income and yield and carry.
Jay Diamond: Where are you finding relative value right now and what are you avoiding?
Evan Serdensky: Well, as we mentioned before, we prefer to remain tilted higher quality, and so the sectors that stick out the most to us right now mostly reside in structured credit, and that's in residential space, for example, or ABS, which is asset-based financings. And the spreads in those sectors are relatively wide versus everything else that we look at for a number of reasons. One, structured credit tends to lag other sectors. It moves a little slower and we've had some really fast moves in the corporate credit space. But two, the typical buyer base is not as involved as they historically have been because a lot of them are sitting on some mark to market losses, which are constraining the mobility of their balance sheet. And so that's pushed relative valuations to around the 90th percentile versus investment-grade corporates. Last year, Agency mortgage-backed securities was a really nice opportunity where those spreads had sort of gapped out for a number of mostly technical reasons, and we made a meaningful allocation to the space that worked out well, but now spreads have tightened to back to basically unchanged levels from before the turmoil in that sector. And so if less interesting, still looks okay from a high quality carry opportunity. But the sectors that we're avoiding right now are lower quality corporates, and then a lot of the commercial real estate space, CMBS in particular, where we think it's just still far too early in the cycle to allocate.
Jay Diamond: So how would you describe your appetite for risk right now?
Evan Serdensky: We’re broadly neutral and running the portfolios somewhere near their historical average risk levels and we've been on a de-risking trend for the last year or so as the cycle has been aging. Our priority has been on eliminating exposure to potential hazards in the market. Luckily, yield is still plentiful and so you don't have to take very much incremental risk above Treasurys and money markets, which are obviously great, but you can get substantial yield enhancements and potential total returns by just going a little bit further out on the risk spectrum.
Jay Diamond: And how about your dry powder balances?
Evan Serdensky: Yeah, I'm glad you brought that up. That's an important component. We've been prioritizing liquidity and diversification and having dry powder because we think we're entering into an environment that could potentially see greater volatility at, again, the sector and security level for the most part. And so we want to be ready to take advantage of those in the portfolios.
Jay Diamond: You know, we always like to end with a roundup of possible black swans or gray swans that are out there. So, what kinds of things are you guys worrying about right now? Matt, let's start with you.
Matt Bush: I think most of these would qualify as gray swans because they are known unknowns. But one of the things where we're focused on is we're in an election year and we've done some work showing how policy uncertainty, unsurprisingly, rises in election years and especially presidential election years. And so given the starkly different policy outcomes of the election, particularly areas like trade, immigration, foreign relations, and the likelihood it's going to be a close race that really comes down to the wire. This uncertainty is going to create some volatility as we go through the year. And we're also already seeing in business surveys that some companies are struggling with making plans because they’re really uncertain of the direction of policy over the next year or two. Another much discussed one, but I think for good reason, is just all the geopolitical hotspots around the world which are hard to predict, but we know they're there. And we just see the number of hotspots rising. Tensions in the Middle East are obviously top of mind, but now we're hearing of escalation risk in Ukraine, tensions rising in Taiwan as their new pro-independence president gets set to take office, and now North Korea is making new threats against South Korea. So, these types of risks typically get pretty ignored by the market until something blows up, and sometimes literally blows up. And then, one final one that I think is, again, a little bit underappreciated is the economic situation in China, which has been a perpetual problem for several years now, but we're seeing an intensification of stress there. Policymakers have failed so far to bring any stability to plunging stock markets in China, which is just eroding confidence further amid this real estate slump, amid questions about financial stability of their local governments. And so far, the slowdown there hasn't really spilled over globally, but it is something we're watching.
Evan Serdensky: So I'd say near-term, one of the pitfalls that I think is probably underrepresented is how this balance sheet dynamic is going to play out. Interestingly, quantitative tightening only garnered one question during the FOMC press conference from reporters at the very end. So, it's clearly not getting a lot of attention. At the same time, certain Fed governors have started raising alarms, saying we need to start looking at this, which is exactly what the Fed has said they're going to start doing. But you could see some issues pop up as reserves are draining pretty quickly now. However, the Fed does have a lot of tools in their tool chest, so it's not something that we think will turn into a big macro risk, but it could lead to some shorter term volatility. And then in the longer term, and we've been focused on this for a while, but it's on the commercial real estate side and the effect that that can have on banks, in particular the regional banks, because that that story is probably not fully written yet, and so we're keeping a close eye on that.
Jay Diamond: Well, that's terrific. Again, guys, I want to thank you for your time. Before we let you go, however, Evan, what's a main takeaway that you would want listeners to come away with after listening to this podcast?
Evan Serdensky: I would just point out that periods of heightened volatility are usually pretty good entry points, and so we're excited about the opportunities set in bonds right now and think that an allocation at this point in the economic cycle, and especially in the monetary policy cycle, favors an allocation of fixed income in one way or another.
Jay Diamond: Great. Matt, any final thoughts for our listeners today?
Matt Bush: Just to say thank you as always for listening in. Between the noisy economic data we walked through, all the uncertainties on the macro front we just talked about, it's really valuable to be able to walk through our views in a longer format, in a more nuanced way, and hopefully our listeners feel the same.
Jay Diamond: Well, speaking for them, I couldn't agree more now. Thanks again for your time, Matt and Evan. Please come again and visit with us soon.
Matt Bush: Thanks, Jay.
Jay Diamond: And thanks to all of you who have joined us for our podcast today. If you like what you are hearing, please rate us five stars. And if you have any questions for Evan or for Matt or any of our other podcast guests, please send them to email@example.com and we will do our best to answer them on a future episode or offline. I'm Jay Diamond and we look forward to gathering again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership, please visit guggenheiminvestments.com/perspectives. So long.
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