Transcript
How has economic data evolved to influence Fed policy at the end of 2024?
Heading into the September Fed meeting, economic data had started to slow, the unemployment rate had ticked up, and inflation was moderating towards the Fed’s 2% target. Seeing this trajectory, the Fed decided to cut interest rates by 50 basis points right out of the gate and give guidance for further cuts. After the interest rate cut, however, the data reversed. The unemployment rate improved, growth remained solid, the labor market showed resilience, and inflation—particularly on the services side—proved to be sticky. The Fed cut interest rates by 25 basis points in November and December, but at their December meeting, they adjusted their expectations for interest rates in 2025 and 2026. This, along with revising inflation expectations upward, took markets somewhat by surprise. Some of the uncertainty is related to the new administration’s policies and the potential impact tariffs will have on inflation and economic activity.
What is your outlook for the path of interest rates and the shape of the yield curve?
One of the themes we discussed in 2024 and believe will continue into 2025 is that all bonds and all parts of the yield curve are not created equal. When the Fed began cutting interest rates in this cycle, the front end of the yield curve fell, but longer-term interest rates actually increased as a function of better economic growth. We think this theme is likely to continue into 2025, given the added uncertainty around policy and heightened market volatility.
I think the path forward for the Fed is at least one more cut in 2025, assuming inflation does not reaccelerate. The more important discussion is related to the neutral rate. As Chairman Powell suggested in December, we are likely closer to the neutral rate now than where the Fed thought neutral was when they started cutting in September. I don’t think the Fed will be able to cut the Fed Funds rate to below 3%, and because of that, the yield curve should continue to steepen, with the front end moving slightly lower and the back end—seven, 10, 30-year bonds—staying at these levels or potentially moving higher.
Given the steeper yield curve, investors should consider extending their maturities and portfolio duration further out the curve to lock in yields significantly higher than current cash rates. This will help reduce reinvestment risk and hedge against riskier parts of an overall asset allocation.
Is the 10-year treasury fairly valued?
Given the current economic environment, we think the 10-year Treasury is fairly valued at roughly 4.5%. Yes, inflation is above target, and yes, there is uncertainty around tariffs and fiscal policies down the road, but I think the bigger driver of the 10-year treasury is where the neutral rate of interest ends up going. We believe that the 2.0-2.5% neutral rate that we saw from 2008-2020 will be the exception and that a 3.5-4.0% neutral rate is normal.
Could the 10-year Treasury retest the 5% level we saw in 2023? You would have to see a lot of factors coming together: more pro-growth policies, higher tariffs, the Fed not cutting at all in 2025, the unemployment rate falling, and inflation rising. One concern is that if rates end up moving higher, it triggers a mark-to-market loss selloff, with investors exiting fixed income at once, driving rates even higher.
What is your outlook for the credit market?
In our opinion, the credit market is priced to perfection. Credit spreads are fully incorporating the strong economic growth and pro-growth fiscal policies that may be coming. We don't see a ton of upside in much of the credit market, particularly when volatility is elevated. There is value in the market, but you have to pursue it from an active standpoint because not everything reflects the risks out there.
For example, investors should be concerned about tight credit spreads in the lower-quality parts of the market, such as low-BBB and high yield bonds. Historically, at the spread levels where these securities are trading, our research shows that the excess return expectations are negative to zero.
Where are you finding opportunities in the credit market?
Given the economic environment, the incoming administration’s pro-business policies, and the expectation that the yield curve continues to steepen, we think the best opportunity is two- to seven-year bank and finance paper. If you look at where those bonds are trading today relative to history and past performance patterns, we still think there is decent value there.
Industrial bonds, especially those of lower quality, are trading very tight. With a potentially pro-business administration, you could see increased M&A activity in the industrial sector. M&A activity is generally negative for industrial bonds as issuers become more leveraged and credit positive for bank and finance paper.
Given the uncertainty with fiscal and monetary policies, we continue to believe higher quality and more liquid securities will allow investors to take advantage of the volatility we are expecting.