As February begins and my favorite prognosticator Punxsutawney Phil brings hope for an early Spring, one thing is abundantly clear, Jerome Powell’s shadow still looms large over the market. The Santa Clause rally, which is now an Energizer Bunny rally is still in full effect for most of the Magnificent 7, as equities finds itself in record territory. The bond market, however, has been a little more cautious post Powell’s pushback – and whether you believe in soft landings or that the Federal Reserve (Fed) will actually need to cut rates six or more times in 2024; be forewarned we are still in a data dependent market.
Let’s get focused.
Lost within Fed’s dots and their dovish summary of economic projections was the fact that they didn’t envision hitting their 2% target until 2026. So, while the economy has made substantial progress on inflation and the data continues to come in supportive, the Fed likely expects the last percent or so of this inflation fight to be the hardest. If you had a hard time following the 180-degree turn from the December to January Federal Open Market Committee (FOMC) meeting and press conference, you were not alone. Market probabilities for a March rate cut were nearly 100% to start the year and have fallen to a lowly 20%. Powell’s pressers have been (good or bad) theatre, depending on your positioning, but I honestly believe he intended to be quite as dovish as his tone reflected in December. Realizing this, the January conference was much more measured and specific, especially around timing, when he basically let the “cat out of the bag” that March cuts were off the table. He followed it up on “60 Minutes” and really left no ambiguity this time around. It was these comments and continued economic strength in areas like Non-Farm Payrolls and Institute of Supply Management (ISM) Services readings that has really pushed rates higher.
To be fair, the same questions the market was asking in 2023, are being of asked of us in 2024; How many cuts will there be and when will they start? In my opinion, March was always going to be too soon. The Fed continues to be in a quandary of seeing disinflationary trends in the pipeline (Rents, Quits, JOLTS, Delinquencies), but not yet seeing enough of it in the actual hard economic data to respond with cuts. Additionally, goods demand (or lack thereof) and supply chain normalization has continued to do most of the heavy lifting of helping the Fed try to achieve their 2% target. Powell spoke about a reacceleration in these areas, especially with geopolitical challenges, and with services sector disinflation still missing in action, the Fed doesn’t not want to cut, only to have to hike like we saw in the 80s.
So, what will the Fed do?
The Fed feels certain that we are in restrictive territory. And, ultimately the Fed is still trying to achieve a soft landing, and wants to avoid putting us into overly restrictive territory for too long a time period. I firmly believe they will cut rates this year, but it doesn’t need to start in March or May, and easing of conditions can begin with tapering from the $90 billing rolling off of the Fed’s balance sheet each month via quantitative tightening. I think tapering would be a helpful signal, as real yields are above 1.8% and, you could argue, that (if) inflation comes down, then those real yields could push higher creating an unnecessarily restrictive backdrop. Unless the Fed is responding to a material weakening in the economy, I would expect quarterly maintenance cuts, while continuing to monitor how the data responds to ensure there’s no re-acceleration. Complicating matters further, will be the geopolitical backdrop in the second half of 2024, which is why I do not believe that the Fed will be in any hurry to force cuts.
Regarding those geopolitical risks, over 60 countries and nearly half of the world’s population will vote this year, and it’s not just about the U.S…there’s EU, UK, Pakistan, Russia, Ukraine, South Africa and India just to name a few. Recently, we witnessed the outcome of Taiwan’s election and it seems the doomsday scenarios with China were less dramatic than expectations. Overall, markets in China have somehow still moved lower. With many countries potentially experiencing leadership changes, there’s uncertainty about outcomes and what knock-on-effects will have on the current status quo, which sadly includes conflicts in Russia-Ukraine, Israel-Gaza, Pakistan, Iran, Yemen, etc. I would note, the accumulation of these tail risks are growing and becoming more complex, despite not being reflected in traditional fear gauges.
Where are we today regarding markets?
Let’s look at treasury auctions, which were a big concern just 4 or 5 months ago. Believe it or not, while some of the 5- and 7-year auctions have had tails, overall demand has found supply for now, especially with the most recent Treasury refunding announcement. Despite an increase in coupon sizes, Janet Yellen was quite optimistic about funding needs for 2024 versus 2023, including Q2 tax receipts and overall revenues. The issuance surprise I found in January actually came from Corporates, where the investment grade sector, especially banks, hit a new record in January with $197 billion in issuance, roughly 58% of that in financial companies. Some of those companies issued at negative concessions to where secondary debt was trading in the market.
So, how do I feel about banks, especially with some of the latest headlines?
Not all banks are created equal. There are over 4,500 actually, and some regional banks continue to have elevated commercial real estate (CRE) exposure and/or underperforming loans, with bad treasury duration hedges. We continue to favor systematically important banks that stand to benefit from continued consolidation and have healthier balance sheets. I also still like short duration treasuries, with a curve stubbornly inverted, the Fed on pause and money market fund assets still at record levels. What would I avoid? Higher for longer rates could start to pressure lower quality credit, especially CCC and leverage loans, so I’d advocate staying up in quality within corporates, while spreads are tight, as you are still being compensated via all-in yields. I would try to lock in some of these yields, while you still can! These are fast markets and as we saw in the short time period between New Year’s and Groundhog Day, market “knowns” can turn into “unknowns” very quickly.
Until then, Stay Focused!
– George