The Issue at Hand by Madison Investments
In this Market Brief, Chris Aleman and Mike Sanders examine what Warsh’s comments and the subsequent market reaction mean for the bond market. They also discuss what the changing outlook and flattening yield curve mean for duration positioning and where investors may find opportunities along the curve.
At the Federal Reserve’s annual Jackson Hole Symposium, Chair Kevin Warsh delivered a hawkish speech that reinforced the Fed’s commitment to a hard 2% inflation target and offered further insight into its “reaction function”, or the inputs that could trigger a change in interest rates. With inflation stubbornly above target, and external pricing pressures lingering, markets are increasingly pricing in the possibility that the Fed will raise interest rates.
Key Takeaways
- Warsh reiterated that inflation remains the Fed’s central concern, and markets responded accordingly.
- A more hawkish Fed outlook has driven a flattening in the yield curve, with short-term rates reflecting an increasing possibility of a hike and longer-term yields more restrained.
- The Fed can influence the front end of the curve, but other factors have greater influence further out the curve.
- Despite the potential for higher short-term rates, investors focused on real yields may find opportunities in the 5- to 7-year portion of the yield curve.
The Discussion
Chris Aleman: Welcome back to The Issue at Hand Market Brief. I’m Chris Aleman, and I’m joined by Head of Fixed Income Mike Sanders. We’re recording this episode on Friday, August 28th, hot off the heels of the Fed Chair Kevin Warsh speaking at the annual Jackson Hole Symposium.
Well, that was a unique presser, Mike. So, I guess let’s just get started – were all of your questions answered? Or, how about you talk about what you were expecting versus what was actually said? Let’s start there.
Mike Sanders: I think going into it, myself and other market participants wanted to understand maybe what the reaction function of the Fed was going to be in terms of changing rates, what mattered to them in some sort of a context. And I think broadly speaking, we got a little bit more information about the reaction function. I think Warsh’s comments regarding the level of inflation, the components of inflation being above target, the labor side is okay, the inflation side is not okay. I think overall it’s definitely been interpreted as a hawkish statement in terms of really reinforcing the 2% price target for PCE and the commitment by the Fed to get there.
Chris Aleman: I think it was pretty interesting that he was very committed to saying that 2% and re-admitted this is what we’re focused on. So, I thought that was kind of cool. What are you seeing in the bond market right now?
Mike Sanders: Going in, we thought if it was a perceived hawkish meeting that the yield curve would flatten. That’s exactly what we have going on right now. The front end, the two-year, is up seven, eight basis points, at least when we’re talking right now.
The 30-year is actually down a little bit in terms of yield. The ten-year is up a little bit, but not really moving that much. And so really what’s going on in the bond market is a higher probability of the Fed moving down the road in terms of hiking rates, which then should cool inflation, and that’s why the long end is moving down and the front end’s moving up.
Chris Aleman: That totally makes sense. Well, going into this, as you said, the bond market was a little volatile leading up to the speech, not just from investors trying to pinpoint the Fed’s next move, but we’ve also had the Treasury announce buyback plans of longer-dated maturities. We’ve renewed tariff threats, we’ve expanded sanctions related to the Iran war. How do you think the Fed views some of these external pressures on the economy and interest rates? Or are they not even considering them?
Mike Sanders: Well, I think they have to think about them. I definitely think they wish they weren’t happening, so it makes their job a little bit easier to get a clean look at what’s going on in the inflation market and labor market and growth. Clearly, it just enhances some of the issues and increases some of the issues that they have in terms of fuel costs, oil – in that inflation side. A little bit more interest rate volatility, a lot more crosscurrents going on in terms of what you’re looking at in the Japanese bond market, look at where European yields are heading. Now there’s a lot of movement across the globe in terms of rates and currencies. And so, I think generally, the Fed can only control what they can control, and that’s the front end of the yield curve in reality.
And I did think it was an interesting statement by Warsh about how the main policy tool that the Fed is going to use is the Fed funds rate. Which means less balance sheet and maybe some of the other parts of the term premium out the curve might be something that the Treasury will have to deal with the buybacks to increase liquidity out the curve, which most likely gets funded with T-bill issuance or a pull down of the TGA. I think the Fed and Warsh have kind of indicated this is going to stay in their lane a little bit more. Focus on policy on the front end of the yield curve, and then maybe in discussion clearly with the Treasury about other parts of the curve going forward.
Chris Aleman: So, given all that, Mike, has your view of the Fed’s next move changed at all after the first hundred days of the new Fed chair?
Mike Sanders: After this meeting, it’s shifted a little bit. Our group was questioning the thought that the Fed would increase rates to fight supply-side issues, with AI spending and energy prices going higher. I think after this meeting, from our own probability distribution, probably shifting a little bit higher to the Fed maybe hiking rates. I don’t know about the next meeting, but by the end of the year I think it’s definitely gone up. And with the movement in Treasuries in the front end, Fed fund probabilities are shifting towards what we were thinking now as well.
So, I would say that it has moved since the beginning of Warsh’s term to after his big speech today.
Chris Aleman: I think that makes sense. I think you’re also slightly making a case for active management. If I can ask a little bit of detail about duration, has this changed your stance on where you think we should be positioned?
Mike Sanders: The concept of pushing out your duration and just trying to lock in these yields in the belly of the curve still makes some sense. If the Fed is going to raise rates sometime in the next three to six months, that’s already built into the market. And so, I think that’s getting reflected in the five-year to seven-year, and where overall spreads are and where overall yields are versus where cash is today and where cash could go down the road if the Fed does raise rates. I still think that’s a pretty good long-term investment. Especially, where real yields are currently in that part of the curve.
Duration may be shifting a little bit longer after this. But I would say maybe pushing it out just a touch because of maybe what the implications are for a slightly more hawkish Fed in terms of where longer-term interest rates may or may not go, and maybe capping the yields slightly given even what the Treasury’s been talking about.
Chris Aleman: That makes sense. Well, thanks, Mike. I appreciate the take, and I think that’s where we should probably end.
This was The Issue at Hand Market Brief, following Fed Chair Kevin Warsh’s speech at the Jackson Hole Symposium. For more of our insights and additional disclosures, visit MadisonInvestments.com.
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