The Issue at Hand by Madison Investments
The Federal Open Market Committee (FOMC) delivered a 25 basis point rate hike at its September meeting, following through on Chairman Warsh’s tough stance on fighting inflation. But if inflation is being driven by forces beyond demand, can higher interest rates actually address those pressures?
In this Market Brief, Chris Aleman and Mike Sanders give their immediate reaction to the policy decision, examine its potential impact on the yield curve, and discuss what the changing rate environment could mean for bond portfolios in the months ahead.
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. It’s September 16th, and the Federal Reserve meeting just concluded. Rates are on the rise, volatility is back, and the Fed has decided to move the Fed funds rate up a quarter of a point. And Fed Reserve Chair just stated, let me read this to you, “Inflation remains elevated. We must be confident that underlying inflation is moving to our objective clearly and at sufficient speed. Today the FOMC decided that this standard has not been satisfied.” So, with all that said, Mike what does all this mean? What’s the market reaction right now telling you?
Mike Sanders: Well the market reaction is kind of pricing in hawk, right? I mean, the front end is rising, twos are off five, six, seven basis points depending on when you look at it. And the back end’s doing okay, right? Thirties are off a little bit from earlier today, but still massively outperforming twos through fives, which is really what will be most impacted by a more hawkish Fed. And so the market’s kind of taking what Warsh said and extrapolating it into more hikes down the road.
Chris Aleman: Yeah, I think one of the things that I thought was interesting, was what impacted the move today. So, was there something in the inflation print last week that forced the Fed to move? Was it the latest import price inflation data or was it simply the economy is overheating and we need to step in?
Mike Sanders: I don’t know if the economy is over hitting heating, per se. I think it’s just more the totality of where inflation is and there’s really no concern on the labor side. Warsh even stated it’s hard to look at what’s going on in the economy, growth, labor, and say that we’re even in slightly restrictive territory. So, I don’t know if it came down to the specific CPI number or the PPI number or what they’ve kind of modeled for PCE, but I think it’s just the totality of inflation being consistently above target, what he talked about in Jackson Hole and the speech he gave about PCE components being above three percent, and now there’s all these diffusion indices about that kind of statement. So I think it’s just a little bit of everything. I don’t know if it was a credibility hike, if you will, but I do think it would have been very disappointing to the market if the hawkish talk was not backed up, when the data didn’t improve really that much, with a hike.
Chris Aleman: I think it was a little bit of a credibility thing, and I think after this we’re going to need an acronym definitions in the back of this. So, was there anything in Walsh’s statement that stood out? One of the things, when I was looking at all the data, that I thought was interesting was the majority of Fed officials expect further tightening. But did anything catch you off guard or was it to be expected?
Mike Sanders: I think clearly the front end of the market (and of Fed funds pricing and what’s being most impacted by changing in policy) was caught a little off guard with how hawkish it seemed, and the market’s now pricing in at least one more hike through year end, and then some more down the road. So I don’t know if anything was really shocking, but the market was leaning maybe a little bit less hawkish, in terms of a hike, and we’d see how it worked out. But clearly given the movement in the two year treasury and how that’s reverberated out the curve, it was definitely not expected in terms of how hawkish he was and the statements that he made.
Chris Aleman: Let me stop you on that one. One of the things you just focused on, the two year, how much of an impact will this have on rates further out the curve? I don’t know if we want to focus three to five, ten, thirty, et cetera.
Mike Sanders: Five years and in will see the biggest impact from Fed policy, obviously. If you just think about one month at a time and how that impacts a two year much more than it will a 30 year. So as we discussed before, the back end of the curve’s doing better. Tens are essentially unchanged, more or less, from yesterday and 30s are a little bit lower, day over day. And so I think any sort of credibility from the Fed that they’re willing to be more aggressive and hike rates should help stabilize the back end of the curve a little bit. Now it’s not to say everybody should be running out and buying 30 year bonds. I think there are some issues out there. If you listened to what Warsh said in terms of the drivers of rates, because he was directly asked, it was AI spending, so some sort of a crowding out effect and competing for capital; It was geopolitical, so that’s the direct Middle East issues; And then it was economic growth. It’s just interesting to me that two of the three will not be changed by the move: what’s going on in the Strait of Hormuz, and it’s not going to change at the margin capex spending for AI. It will take really hurting the demand side to offset some of these inflation pressures, and I think that may be why risk assets are also taking it on the chin. Hawkish Fed, they have to hit the demand side of the economy. They can’t fix the supply side shocks. And you know that’s kind of what we get.
Chris Aleman: Got it. I want to switch gears a little bit because I want to mention a different department that’s had an impact on all of this. The Treasury Department’s announcement last week. Secretary Bessent stated that the department would begin buying back $6 billion worth of government debt. Does that have any impact on borrowing costs as well, or is it more just outside noise?
Mike Sanders: It clearly didn’t work. Rates are a lot higher now than when that was first announced and first implemented. In terms of if we want to use analogies, you know, the Brewers just clinched the central for baseball. You’d have to bring a much bigger bat now, if they want to use the impact of treasury buybacks out the curve. They have the ability to, in terms of raising rates or telling the market you’re going to imply rates will do much more from my perspective to impact tens to thirties than the Treasury trying to get involved in that. It clearly hasn’t worked because if it mattered a lot, you wouldn’t have rates a good amount above the level they were at when it was first announced and implemented, if you will.
Chris Aleman: Got it. Well before I forget, go Braves. Based on what I’m reading from you is the Fed is taking the latest inflation data seriously, that the quarter point hike may not be the only move this year, right? So let’s end on this: What should fixed income investors be paying attention to over the next few months?
Mike Sanders: I think the biggest thing that investors should really focus on is where all in yields are today. If you think about where the yield on a five year bond or a ten year bond, maybe not so much out the curve, it’s at the highest levels as we’ve seen in twenty years in a lot of cases, especially as you move out the curve, if you will. But I think just from an investor standpoint, don’t be concerned about a little bit of volatility in the yield curve inside of ten years because at the margin it’s not going to matter a lot. I mean you would have to have such a massive rise in interest rates in the front end of the curve to really impact pricing over extended periods of time because of those yields. There’ll be a lot of Fed speak over the coming weeks and we’ll get more data, but I just think that investors should not be as concerned with the daily movements. Just thinking about it in the longer term, where real yields are, the Fed’s fighting inflation. Those are the kind of themes that you should think about as an investor on the bond side and take that in consideration when deciding what to do with your own fixed income securities.
Chris Aleman: Well let me stop you right there because one of the things I was asked this the other day as I’m defending fixed income right now and I think we have a number of clients who would just be interested in… Do I keep my money on the sidelines and not go into bonds yet because I have a feeling that rates are going to continue to rise? Or is it more to exactly your point, that you would have to have a much larger rise to truly have a negative impact? Is that kind of what you’re saying?
Mike Sanders: There are very few investors and if they do it once, they just got lucky, that will pick the top in yields and know when to go in. I think a longer-term approach has to be in here. And if you bought earlier and rates are higher, in reality it just provides opportunities to shift and gain some more yield in a portfolio. So, longer term approach, like people look at it on the equity side, it’s a longer term time frame. We’re going to be a long term investor. Don’t get caught up in small moves in rates, it’s won’t really matter in the long run. You’re going to have the backing of where yields are that’s really going to balance out a portfolio. There’s a lot of income back in fixed income and I think that’s the better approach to take.
Now it’s not the same for everything. Thirties aren’t for everybody to own. There are special situations that you should own that part of the yield curve, but just fixed income in general is, relative to cash and everything else, an attractive asset class.
Chris Aleman: One of the key words you said there was income and I think people sometimes forget what the income levels are versus what they were a few years ago, that you have that built in buffer. Mike, I appreciate your thoughts as always. Thank you for joining us on the Market Brief. Thank you everyone for joining. You can access additional information and disclosures at MadisonInvestments.com. And if you like our conversations, please remember to subscribe. Take care.