Following 14 months of the Fed hiking interest rates, will the Fed start cutting rates this year? Mike Sanders, Head of Madison Fixed Income, weighs in on this question, the current state of bond markets, and how an active fixed income manager can navigate this volatility.
Transcript:
Leslie Oliversen 00:04
Hello, and welcome to another installment of our conversations with the portfolio manager series. I'm Leslie Oliversen, head of key accounts here at Madison investments. And I am joined today by Madison's head of fixed income and portfolio manager Mike Sanders. Welcome, Mike.
Mike Sanders 00:20
Thanks for having me.
Leslie Oliversen 00:23
Mike, let's start with interest rates, the Federal Reserve has taken rates from zero to 5%. In just 14 months, the market expects one more hike then cuts later this year. This is despite the Feds higher for longer projection, how does the market wrong or what is being overlooked?
Mike Sanders 00:40
Yeah, that's that's really the question that we had coming into the year, you know, was the Fed going to cut interest rates by the end of 23 to help boost the market in terms of slower economic growth and much less inflation out there. And our view currently, you know, given the data that we're seeing is that, you know, the Fed is going to be able to keep interest rates higher, because there's going to be a slower disinflationary path than what the market expects. Inflation is still running north of the 2% target. Unemployment rate is still below 4%. wage growth, as measured by the Atlanta Fed, wage tracker is still north of 6%. And economic growth, while the slowing is still good enough that the Fed doesn't have to worry about larger impact to the overall economy. So it is our view that the Fed is going to keep rates higher for longer. In fact, if you look at the last summary of economic projections, during the March meeting, the Fed indicated that the unemployment rate was going to rise to four and a half percent, inflation measures would still be around three, yet the Fed still thought that the Fed funds rate would be roughly 5%. And so the Fed understands that unemployment is going to have to rise, but they still think that the first fight they have to win is is the inflation fight. And therefore we still don't think that the Fed is going to need to cut interest rates by year end, because we don't think that the economic deterioration is going to accelerate enough to have that have to happen. You know, clearly the banking issues that have come up, you know, might throw a little bit of of a curveball into that. But I think really, the Fed was planning on going north of that five and an eighth effective Fed funds rate prior to the banking issues. So the banking issues that have popped up have probably reduced the number of cuts the Feds willing to do, but I don't think that really changes the Feds outlook in terms of having to cut rates by 23. I still think they're committed to keeping rates higher, to really kind of push inflation back to their long term target.
Leslie Oliversen 02:51
Yeah. So what can you say about the state of credit spreads? Is a recession priced into the bond market? are investors being adequately rewarded for taking on risk?
Mike Sanders 03:00
Yeah, so credit spreads, you know, have, there's been a divergence in terms of the of the credit markets, you know, after the Silicon Valley Bank issues popped up, spreads widen out. But since the Feds kind of enacted a couple of programs to help liquidity at banks, you've really seen industrial bonds tighten quite significantly while financials have come off the wise, but they're still a little bit wider, in some cases than than where they were pre Silicon Valley Bank. So in our opinion, the credit markets have not are not pricing in at least the possibility that you could have a larger slowdown in the economy, or at least the deterioration in credit fundamentals will begin. And we've probably seen the peak in terms of credit, credit quality. And so, you know, we don't think that in certain areas of the credit market, you're getting compensated well enough to take on that credit risk. And that's why, you know, in our view act, an active credit management approach is the way to go in these kinds of scenarios where you've peaked, you want to stay higher quality, they're all in yields are still quite attractive north of 4% in an intermediate, high quality government corporate strategy. So you don't have to stretch to really earn very good yield relative to recent history, but it is more downside out there given the possibility that, you know, we could see more volatility in the economy. And so, you know, parts of the credit markets are attractive in our opinion, but other parts are a little bit too tight given the range of possible outcomes. Now, we still believe the economy will do okay in the next three to six months. But I think, you know, the discounting mechanism by the market might might push spreads wider by by the end of the year and into 2024. I think investors need to be prepared for that.
Leslie Oliversen 04:58
Thanks. Speaking of 4% yield in bonds, you know, some investors see a 4% yielding money market fund, or even a high yield savings account and think that it's a safer bet than investing in a bond portfolio. how viable is this investment strategy? And what might investors be overlooking?
Mike Sanders 05:17
Yeah, it's definitely something that you've heard more about in the news. And it really comes down to your asset allocation view and terms of do you look at cash as an asset class? And how do you look at fixed income. And really, the difference between investing in a high yielding money market accounts, and buying a bond is really the reinvestment risk that you're taking if if the Fed does have to cut interest rates, and interest rates will be falling. Most of the time, you know, bonds that have longer maturities will also have lower interest rates. So by optically having a good read good investment opportunity, by investing in a cash type security, you're giving up some of the security, the guaranteed income stream of locking in longer bonds. And so while over short periods of time holding cash is maybe superior to fixed income in a broader sense. And I think, really, if you're looking at an asset allocation basis, and kind of locking in future income and cash flows, you know, it's really about managing the reinvestment risk and how you think about fixed income and overall asset allocation.
Leslie Oliversen 06:53
bankruptcies and credit rating downgrades seem to be picking up this year recession or not, is credit declining in a broad sense? And how do you and and the team stay in front of credit risk?
Mike Sanders 07:04
So yeah, it could be credit fundamentals are deteriorating, the economy is slowing, you've seen some of the unemployment, the lower unemployment rates, and the wage growth affecting some businesses and commodities are still higher. So in a broader sense, I think credit fundamentals have peaked. That doesn't mean that you sell all your credit, I just think you have to be much more selective when you enter into buying corporate bonds. And again, that's why I think from an active management approach, when you're at these cycle peaks and possible shifts in the economic outlook. You know, having an active approach to fixed income, especially on the credit side makes a lot of sense, in our opinion. And again, you know, lacking in higher yields of high quality bonds, when you're getting paid to own those credits, in our opinion, is very attractive at the current moment. And it's something that we're very aware of, and when we're looking at these investments, it's it's not what the fundamentals look like over the next three months, but it's more about the six to 12 to 18 months down the road.
Leslie Oliversen 08:10
And I think that's a great point. I think emphasizing that you and the team have the individual bond research on each credit is one of the benefits of the active management here at Madison investments.
Mike Sanders 08:22
I agree with you, Leslie.
Leslie Oliversen 08:24
Great. Well, I think this is a great place to end. Mike, I really appreciate you taking the time to share your thoughts today. Again, Mike Sanders is head of fixed income and portfolio manager at Madison investments. To watch more of our conversations with the pm series. or to learn more about Madison investment strategies, please visit Madison investments.com or reach out to your regional director in your area. Thanks for tuning in.
Mike Sanders is Head of Madison Fixed Income.