Macro Markets Podcast Episode 53: The Wide Opportunity Set in Bonds and Asymmetric Future Fed Policy
It’s been 10 months since the Fed’s last rate hike and Evan Serdensky, Portfolio Manager on our Total Return team, and Matt Bush, our U.S. Economist, join Macro Markets to discuss what’s next for the economy and markets.
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. Now, before we begin, I want to acknowledge all of you for tuning in and supporting our podcast. Our listenership keeps growing and the feedback we've been getting is terrific. So, thank you for that. I also want to make sure everyone knows that we welcome your engagement, so please feel free to send us your thoughts or questions about our podcast or ideas for future podcasts and send them to macromarkets@guggenheiminvestments.com. That's macromarkets@guggenheiminvestments.com. All right. Let's get started. We're nearing the end of the first half of what has been a fairly volatile year in the bond market, although stocks continue to bull ahead. And on a very high level, the macroeconomic data is still a little murky. All in all, it seems like a good time to do a situational gut check on the macro and the market perspectives. And here to help us do that is Matt Bush, our U.S. Economist, and Evan Serdensky, Portfolio Manager on our Total Return Team. Welcome back, Matt and Evan, and thanks for taking the time to chat with us today.
Matt Bush: Great to be with you, Jay.
Evan Serdensky: Thanks for having us, Jay.
Jay Diamond: Of course. Now let's start with you, Matt. It's been ten months since the last rate hike in the Fed's inflation fighting battle. So where do you think we are in this fight? And who is winning?
Matt Bush: Well, throughout much of last year, it looked like the Fed was decisively winning the inflation battle. We saw core PCE inflation get down below 2 percent annualized in the last six months of 2023 actually, and so it looked like maybe the battle was already over. And they were doing it in a way where there really wasn't much damage to the overall economy, with real GDP growth coming in at a really solid 3 percent last year. Of course, the start of this year then saw a setback in that inflation battle. We saw monthly inflation readings reaccelerating, causing some concern that maybe the Fed would have to step back in and tighten policy further. Now the good news on that front is we got the April CPI report and it did show the monthly pace of inflation stepping down from the elevated rates we saw earlier in the year. And that was helped by both the big rental inflation component cooling further and broader services inflation coming down. So, I think the April data helps confirm the idea that the overall disinflation process is still on track, but some of these idiosyncratic factors to start the year were just temporary or dare I say, transitory, interruptions. And so, we don't think these factors are going to persist. Things like excessive seasonality that tends to push up Q1 inflation data or some of the huge gains we're seeing in auto insurance inflation in the CPI data, or really niche topics like imputed financial services in the PCE data. These aren't signs of broad underlying inflation. They're kind of just temporary spikes that should reverse. So, we continue to have a positive outlook on inflation. There are some unfavorable base effects coming up, meaning that the year-over-year rate of inflation is going to be slow to come down. But if you look at something like a 3- or 6-month rate of inflation, which the Fed also looks at, I think you'll see those fall back below 2.5 percent in the second half of the year, and that's going to give the Fed a lot of confidence that inflation is on the right track.
Jay Diamond: Now, Matt, we also got the April jobs numbers a couple of weeks ago. What did that report tell you?
Matt Bush: It was kind of similar to the April inflation data, where the jobs report told us the labor market is cooling off. So, we saw a step down in the pace of job growth in April. Job growth came in at 175,000 after averaging closer to 270,000 the first three months of the year. And stepping back, the labor market is in kind of an interesting place right now where labor demand has really cooled off with the hiring rate actually around ten-year lows, but the rate of layoffs is still near all-time lows, and quitting has really cooled down after spiking in 2021 and 2022. So, if you net all those out, the overall rate of job growth is just gradually coming down, but under the surface, there's not a lot of labor market churn going; things are kind of just frozen in place. And one place you see that reflected is in wage growth, which the April data confirmed was cooling off. It came in at just 2.5 percent annualized in April. And that's another reason we'll feel good about the inflation outlook with wage growth cooling. So overall, the jobs numbers, at least in the most recent month, were fairly goldilocks, job growth cooling but not collapsing. You see better supply and demand balance for workers, helping wage growth come down. And looking forward, we think we'll kind of see this continued slow grind toward a weaker labor market, going from 3.9 percent on the unemployment rate currently to somewhere around 4.3 by the end of the year.
Jay Diamond: Well, interesting. Now, with all this as background, Matt, what's the growth outlook?
Matt Bush: It's similar to the jobs outlook, and that's by design because the labor market drives a lot of the overall growth story. So, our baseline outlook is for a gradual slowdown in real GDP growth from 3 percent last year to about 2 percent by the end of this year, and somewhere between 1.5 to 2 percent next year. So, on the positive side of things, we've seen a pretty meaningful easing in financial conditions over the last six months or so. We've seen credit spreads tightening, equity markets making new highs and that's a positive both for corporate investment activity and also a positive wealth effect on consumer spending. On the other hand, though, we do see that some of the excess cash balances or extra savings for the consumer are run down, especially for the low end of the distribution who is more reliant on that source of funds. And with job growth and wage growth going down, as I mentioned, and the decline in inflation easing, real income growth is starting to moderate. And so that will weigh on consumption. So, netting it out, we see, you know, what we think is kind of a benign slowdown with growth gradually cooling. But we are still attentive to downside risk to the economy. There are areas that are still experiencing a lot of stress in the high-rate environment. For now, those look contained, but eventually those could become a broader problem.
Jay Diamond: Now the Fed paused again at its last FOMC meeting, but the Fedspeak right now seems far from unified about what the next steps might be. What's your view on the course of Fed policy from here?
Matt Bush: Well, I think those high inflation readings to start the year were a definite setback for the Fed's desire to start rate cuts. They really reset the bar for the evidence the Fed needs to see that inflation is coming down. But I think the Fed's underlying view of the economy hasn't really changed in recent months, and Powell made that point recently that the overall story is the same. I see a Fed that's eager to begin the rate cut process, recognizing that tight policy is causing strains and that some of the factors that have helped offset tight monetary policy, factors like easy fiscal policy and high immigration, can't be counted on to last forever to kind of mask the pain from high interest rates. So, our view is that if the next few inflation reports continue to trend in the right direction, we could see the first rate cut as soon as September, likely followed by another in December. That is a big if, though. If there's anything the last couple of years have taught us that the data doesn't always move on a straight line, and there's a lot of potential for surprises. So, if we did get another hot inflation print the next few months, there is a meaningful risk that rate cuts get pushed all the way into 2025. But I think whether it's September or early 2025 when rate cuts start, I think the important part from an investment standpoint is this asymmetry in Fed policy that they've pretty explicitly laid out. If inflation stays elevated, they just leave policy unchanged. If it comes down, they cut. Rate hikes really are off the table at this point, And Powell made that clear at the last meeting, even with the bad inflation data to start the year. And second, either lower inflation or a weaker labor market give you rate cuts, and only higher inflation, not a strong labor market, gets rates to stay unchanged. So, there's just a lot of asymmetry in Fed policy tilted toward the downside or toward rate cuts, and I think that will limit how far longer-term interest rates can rise and also helps reduce interest rate volatility if you're removing that right tail from the rates distribution. And so, I think both of those are positive for the fixed income market.
Jay Diamond: So in the longer term, Matt, where does Fed policy ultimately end up?
Matt Bush: So, thinking longer term this is where the concept of the neutral rate comes in, which is the rate that policy would converge to if there were no shocks acting on the economy, and Fed policy wanted to be either adding or subtracting to economic growth. And so, our view is that the neutral rate has clearly risen from the last cycle, when it was around 2.5 percent in terms of the nominal Fed funds rate. Given how much resilience the economy has demonstrated to higher interest rates, that alone argues for neutral being higher. And then when you look at some of the structural drivers of investment demand in the economy right now, factors like huge CapEx spending for artificial intelligence and for the green energy transition and for reshoring manufacturing production added to wider government budget deficits, all these factors point to reasons why you would see a higher neutral interest rate for the economy. So, we think neutral is somewhere in the 3.25 to 3.5 percent area. And so that's where we see the Fed ultimately ending up by early 2026.
Jay Diamond: Well, thank you for all that Matt. Evan, let's turn to you and talk about what's happening in the market. And let's start with the rate environment. Now, the first four and a half months of 2024, as I said, have been pretty volatile but relatively rangebound as markets have reacted to the data releases that Matt just discussed. So, sitting in your seat, how does an active fixed income manager prepare for and manage through this kind of volatility?
Evan Serdensky: I think the first thing to note is that higher all-in yields serve as a buffer to the volatility that the market's been experiencing. So, to give you an example, a 5-year Treasury today yields around 4.5 percent. It would take a 100 basis point rise in yields to wipe out the coupon return of that bond over the course of the next year. In other words, to solve for a 0 percent return on that Treasury. And on the other side, if yields were to fall by 100 basis points, the total return on that 5-year Treasury would be approaching 10 percent over the course of the year, about half coming from income, half coming from price appreciation. And so that's a really interesting asymmetric return profile right now for investors, and that's why we've seen a lot of known traditional buyers of fixed income reenter the markets at these higher all-in yields. With regards to duration positioning more broadly, we generally try to take a strategic view, but we do also want to use the volatility to our advantage. And so, our general view is that rates are going to remain in a range--speaking about the 10-year--of around 4 to 5 percent. There's a lot of resistance at 5 percent, which is where yields peaked out locally in October of last year, and there's a lot of buyers at that point. You also increase the stress in the system to interest rate sensitive parts of the market at 5 percent. So, it would take a lot to kind of go above that level. Similarly, to get below 4 percent, we'd have to see a pretty major downshift in the inflation outlook or growth, and both of those are going to continue to run a little bit above pace for the near to medium term. So, we think the 10-year will finish closer to 4 percent than to 5 by the end of the year, but we're respecting the range and we're modulating duration accordingly. So, as we get up higher in the range, we're adding duration and then we're taking it off as we get lower.
Jay Diamond: So Evan, given the house view that Matt laid out in general, what's your view on the yield curve going forward? And therefore, are you thinking about changing anything with regard to duration positioning as a result?
Evan Serdensky: So I already touched on duration positioning a little bit, and our strategic view again is to be modestly overweight duration, expecting rates to finish in the lower end of that range, but the yield curve shape is sort of an interesting topic right now. The yield curve is extremely flat and inverted in various parts of the curve. And as Matt walked through, we think the Fed's next move is a cut. They also think that they've taken hikes essentially off the table. So that would serve to steepen the curve with the front end coming down in the back end, maybe modestly rising a little bit. The problem is, year to date, the economic data has been so strong that it's sort of pinned the Fed into a tough position and they can't start lowering rates from here. And so, we're in an inverted yield curve for a longer environment, and so when you're in that environment you have to be very thoughtful on carry positioning. Because in a steepener you actually tend to bleed carry a little bit, and so we're trying to be very thoughtful around that and neutralizing that, but we continue to like a very modest steepener because statistically it's probably the next move.
Jay Diamond: So almost without exception across sectors, while yields remain relatively attractive, spreads have been grinding tighter. So, what do tighter spreads typically mean to you, and how do you balance this tight spreads versus attractive yields mechanism?
Evan Serdensky: So, you're right, spreads have come in a decent amount. The investment-grade index for example, started the year a little bit above 100 basis point spread. It's now sitting at around 87 basis points above the Treasury curve. And I think that that reflects the strong economic data that we've had for the most part, but you do have to acknowledge, as you asked about spreads versus yield, we are getting more of our potential returns from an elevated base rate, which translates into higher carry. And your capital appreciation in bonds will have to come to some degree from yields moving lower. So, in this environment, when all spreads have kind of become compressed, it makes us more biased towards higher quality parts of the market. And our research shows that, especially in this part of the monetary policy cycle, where the Fed is in a pause phase and the next move is a cut, that's when high quality fixed income tends to outperform most other risk asset classes. But I would note that we are finding a lot of value in spread markets, but just looking outside of traditional indices and many of these kind of picked-over areas.
Jay Diamond: Like what?
Evan Serdensky: So, our favorite area is structured credit--which we've covered on previous podcasts, so I won't belabor the point--but it really has the best relative value, spreads have lagged there versus other segments and you can really get high quality collateral pools. And it tends to be a market that has shorter duration, which translates to lower risk. But I'd say one other area that we're really excited about is this sort of developing theme across fixed income in a kind of new economic order where there's a lot of need to finance major infrastructure projects and localizing of supply chains. You're seeing a lot of that financing need come to the bond market. So traditionally, infrastructure funds would be financing this, and they still are, but the needs are so high that all facets of the fixed income universe are being looked at to finance these sort of transactions. So that's the structured market, the investment-grade markets, high yield, the private market. And what's really interesting about these investments is that they aren't tied to the business cycle. These are very low-cyclicality investments, secular growth areas that won't trade with the broader economic cycle. And so, examples are digital infrastructure like data centers, which is mostly being financed through the ABS market, L&G export facilities, mostly through the corporate markets, and then semiconductor plants or fabs, as the CHIPS Act has subsidized some of this new build. They're financing some of that through the bond market. So, these are really exciting places. And you can get spreads that are in some cases double that of more well-known credit stories. And that's perfect for us. We like to focus on more complex structures, fragmented projects, but in general, we're just really excited about the growing opportunity set because we don't feel backed into a corner to finance less interesting areas at much tighter spreads now.
Jay Diamond: Given what you said about credit quality, are you constructive on high yield?
Evan Serdensky: So, default rates are ticking up, and I think that they're probably a little higher than you see in many metrics that don't capture distressed exchanges and severities are a little worse too. But at the same time yields are barely really elevated. So, the high yield market yields just inside 8 percent right now. And then if you look at the highest quality rung, the BB part of the market, that yields in the high 6s. So that's not bad in our opinion, and there's always opportunities across high yield that are exciting. Where we're most constructive is in that BB category, in the higher quality part of the market. And one particular area that we've been focused on is front end high quality, because there's an actual interesting total return opportunity right now. High yield companies that moved their maturities out in 2020 and 2021, they locked in pretty low coupons. Now those bonds are due in the next 1 to 3 years. Because these were pretty low coupons, they're all trading below par, but high yield companies generally don't wait for the last minute, at maturity date to refinance. So, they like to call these bonds early and push out maturities even though they'll be doing so at a higher interest rate. And so being able to buy in the front end BB credit in the low to mid 6s is interesting because you have the potential to earn and take out scenarios upwards of 7 to 7.5 percent. So that's a really exciting part of the high yield market that we think is worth deploying capital to.
Jay Diamond: Thanks, Evan, for that. Now, Matt, back to you. looking beyond the data that we discussed and maybe even beyond our shores, what are some exogenous factors that you and your team are looking at?
Matt Bush: The direction of U.S government policy is definitely a big wildcard for us, particularly after the election. With election polls so tight, it's hard to have any conviction on the actual outcome. And then there's some big policy decisions on the table in 2025, and probably the biggest of those is extending the 2017 tax cuts that expire at the end of next year. So fully extending these would cost around $3.5 trillion over ten years. That would significantly exacerbate the already very elevated budget deficits that we're facing. And both parties have expressed support for extending at least some of these provisions, and so if we don't have revenue raising offsets, you could see the reemergence of concerns around US debt sustainability that drove interest rates higher last year and you could see that return next year. And also on the policy front, there's also some large tariff proposals on the table. Just recently we saw new tariff announcements on China by the Biden administration that showed tensions are already heightened and are probably just going to get worse given rhetoric around the election and China's own push to ramp up their exports as they try to offset a pretty weak domestic economy there. And so, while tariffs technically are just a onetime price increase, if we did see more of those enacted, they could cause inflation concerns to reemerge and derail what's otherwise a pretty positive outlook for inflation. So, this policy outlook is uncertain. It's hard to know exactly what will happen, but for us it's one of the bigger risk factors to our outlook.
Jay Diamond: And Evan, looking beyond some of the market dynamics we just finished talking about, what are some of the things that are on the radar of you and your team?
Evan Serdensky: So, the election is definitely in the back of our mind on every decision that we're making. We have to consider how would the outcome of the election impact any of these investments. Also, just the general speed of moves in the macro arena right now are sort of concerning. The depreciation of the yen is a good example of that. It potentially has a lot of knock-on effects. Besides that, and sort of the more obvious spots--as a reminder, we’re bond managers we’re always concerned around things--but complacency is becoming a real concern as spreads have tightened. Luckily though, as we've already talked about, the opportunity set is very wide right now and we're finding plenty of ways to generate returns and yields without taking significant risks in this environment.
Jay Diamond: That's great. Listen, I appreciate both of you spending time with us today, but before I let you go, Matt, what's the main takeaway that you would want our listeners to have from our conversation today?
Matt Bush: I'd say the main takeaway is that economic conditions look pretty good right now. Despite all the noise in the data, you're looking at consumer and business balance sheets, they are really healthy in aggregate. As I said, we think inflation should resume its downtrend and finish that last mile of getting back to target, and so with that we should see some economic relief as interest rates come down. So, we have what we think is a pretty benign baseline outlook, but we still do see risks kind of tilted toward the downside. Certain segments of the economy, like small businesses, like commercial real estate, continue to struggle with higher rates. And so, if for whatever reason, rates aren't able to fall as quickly as we expect, you know, there could be some emerging strains from those areas.
Jay Diamond: And, Evan, any final thoughts from you?
Evan Serdensky: I'd just like to extend a thank you to all of our listeners. We really appreciate the support, and we love the listener mail. So please continue to have that coming in and we'll address it on future podcasts.
Jay Diamond: Great. Thank you Matt. Thank you Evan. Thanks for your time and I hope you'll come back and visit with us again soon to keep making us smarter. 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 Matt or Evan or any of our other podcast guests, please send them to macromarkets@guggenheiminvestments.com, and we will do our best to answer them on a future episode or offline. I'm Jay Diamond. 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 us at guggenheiminvestments.com/perspectives. So long!
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