The first quarter of 2024 saw global equity performance fueled by expectations of looser monetary policy just over the horizon, as the scourge of inflation died a slow but assured death in the very near future. Chairperson Powell’s dovish pivot towards the end of 2023 was based on this premise.
The risk markets were overjoyed by the “Dot Plot” chart provided by the Fed in December, showing committee members expectations for future interest rate levels. While this data did show expectations of Fed easing (lowering rates) during 2024, the markets took the three cuts expected, and began to price in up to three or four additional rate cuts on top of those forecasted (7-8 total cuts).
Stocks moved broadly higher given the change of stance and the market’s belief that rates would come down even faster than the Fed was predicting.
This expectation was quickly challenged as strong GDP growth, good employment numbers, and hotter than predicted inflation data consistently printed during Q1.
The number of rate cuts priced into the market gradually declined to equal the Feds expectation of three, and eventually fell to roughly one. In April, as interest rates rose to reflect the likelihood of a, “higher for longer,” scenario, the equity markets gave back some, though not all, of their gains.
Source: FactSet, Federal Reserve, J.P. Morgan Asset Management. Guide to the Markets – U.S. Data are as of March 31, 2024.
This adjustment higher in rates has pressured bond prices, leading to negative year-to-date returns in most categories during Q1. This pressure did not let up in April, further impairing 2024 bond returns. The upside to these less than stellar returns is that for the first time in over a decade, the yields offered by these fixed income investments are larger than the price drawdown that has been experienced. That means that if interest rates stabilize, and the bonds simply earn their yield going forward, the negative price impact will be erased in less than a year, and in some cases, after just a few months. This ability to quickly recover from reasonable increases in interest rates, a “self-healing” process, highlights how fixed income as an asset class has largely de-risked itself to a significant degree over the past few years as rates approached 20-year highs.
While absolute yield levels are attractive across the bond markets, there are some areas which look slightly expensive on some measures. The spread, or additional yield above Treasury bond interest rates, that is offered by corporate bonds (Investment Grade and High Yield), looks a little rich. While corporate bonds
Source: Bloomberg, Morgan Stanley Research
have performed very well recently, the value offered by owning them at today’s valuation levels has diminished. This is particularly true when looking at investment grade corporate bonds beyond 10 years to maturity. The valuation is being pushed to an extreme level by significant demand for bonds with these characteristics. The rise in interest rates has reduced the present value of pension plan liabilities, while the gains in the equity markets have increased the value of pension plan assets. This has spurred many pension plans to de-risk their portfolios, implementing Liability Driven Investing (LDI) strategies which entail selling stocks and buying long dated bonds, particularly investment grade corporates.
Other parts of the fixed income market offer more potential. Structured credit (CLOs), Asset Backed Securities (ABS), and Mortgage Backed Securities (MBS) all offer historically attractive return opportunities. These are under owned parts of the fixed income market, perhaps due to the additional complexity and historically limited venues of access for investors. This has evolved more recently, and accessing these assets has become fairly straightforward.
More broadly, with equity markets hovering near all-time highs, there is also a compelling opportunity for non-pension investment accounts to rebalance towards or transition to fixed income, while interest rates are at very attractive levels. Yields are high enough that bonds may be able to produce equity like returns in the next few years, with less volatility.
Limiting the duration of bond portfolios has been accretive to returns as rates have moved higher the past few years. Historically, when the Fed has finished hiking rates, longer Duration bonds have offered better returns than money market funds (MMF) and other short-term bond exposures. Not only does extending the average maturity of a bond portfolio allow the investor to lock in today’s attractive yields for a longer period of time, but it also offers the potential of price upside if rates decline in the future.
The Fed suggested that they would cut this year, and they really do not want to be wrong. The data moved against them in the first quarter of the year. More recently, GDP growth slowed, and employment data cooled. These are the types of economic releases the Fed needs to see to justify a reduction in interest rates. Chairperson Powell still needs inflation to confirm the trend by resuming last year’s trend lower before relief from rate cuts can be recognized. Consumers looking to take out a mortgage would benefit from lower borrowing rates, as would the U.S. Treasury, which is currently on pace to pay $1 Trillion in interest on the national debt, rising to almost $2 Trillion in 2025 if rate cuts do not materialize.
The current pause in monetary policy that we are in the midst of is already one of the longest on record, only exceeded by the pause preceding the Great Financial Crisis (GFC).
The size of the current deficit spending (stimulus) is a likely explanation for the length of the pause. Restrictive monetary policy has been offset to some degree (if not to a significant degree) by this stimulus, fueling the continued strong economic growth.
Whoever wins the White House in November’s election will be facing a large budget deficit and rising financing costs. Chairperson Powell will need to steel himself to avoid being influenced by the coming political pressures for monetary policy relief.
We encourage you to reach out with any questions on the markets or our current positioning.
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Timothy Calkins, CFA
Co-Chief Investment Officer
Timothy serves as a member of the Nottingham Investment Policy Committee. He brings over 22 years of investment experience to the team. Timothy is responsible for corporate and municipal credit research & trading, as well as contributing to our economic outlook and interest rate expectations. He also leads our alternative investment research and custom allocations, with a focus on private credit and liquid alternatives. Timothy’s membership and active participation with the Buffalo Angels group keep him connected to the local start-up community.
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