What were the primary drivers of lower interest rates in the fourth quarter?
The move down in interest rates can be attributed to two developments. First, the Treasury pushed off issuance of further-out-the-curve bonds in favor of more Treasury Bill and shorter duration issuance, which altered the supply/demand balance. In addition, the Federal Reserve, citing better inflation data, talked for the first time about how they may have attained peak interest rate levels and shifted their focus from inflation concerns to economic growth. That, coupled with the expectation of three cuts in 2024, set rates on a downward trajectory. As rates fell, risk assets such as credit spreads and equities fully priced in a soft landing scenario.
The big question for 2024 is whether inflation will continue to move down in a way that allows the Fed to follow through on its rate cuts. The other offshoot of that is whether the Fed will meet the market’s expectations in terms of rate cuts. There is about 75 basis points of difference between what the market is expecting, roughly 150 basis points, and what the Fed is indicating through their economic projections, which is 75. How that reconciles, whether it’s the Fed moving towards the market or the market moving towards the Fed, will be a significant driver in 2024. And then, what will an economic slowdown look like? Every hard landing looks like a soft landing at some point. So, time will tell how the tight policy from the Fed will impact various parts of the economy.
How do you approach portfolio construction with rate cuts on the horizon?
I think there is a slight misnomer about rate cuts: if interest rates fall, rates across the yield curve will all fall by the same amount. Realistically, it is much more nuanced than that. Short-term bonds are influenced much more by Fed policy than longer bonds, where there is much more uncertainty. Falling interest rates signify that we’re closer to economic growth down the line; therefore, inflation could rise. So, long-term bonds could actually move up. When building a portfolio, you must think about all parts of the yield curve. It’s not as clear-cut as simply buying duration, assuming that longer duration will outperform. Given our expectations of when and how many cuts we think the Fed will make, we are positioning bonds across the curve. If the Fed doesn’t have to cut all the way back down to 2-2.5% and they only have to get to 3-3.5%, that could have pretty significant consequences for longer-term bonds, given where they are trading today.
What themes or ideas should investors be considering in 2024?
The investment themes we’re looking at in 2024 include how to position portfolios for a disinversion of the yield curve. We believe the Fed will be cutting rates 75 to 125 basis points in 2024, and we will likely have a flat to positively-sloping yield curve by the end of the year. So, yield curve positioning is one of the things we are focusing on. I think there is a likely outcome that the Fed doesn’t have to cut as much, in aggregate, and that rates further out the curve move higher. Positioning more conservatively in the front end versus the back end, I think, will be a positive attribute for performance in a portfolio. Another thing worth watching in 2024 is credit spreads, given how much performance has been pulled forward with the expectation of a soft landing. We’re not saying that there will be a recession, but we have to be aware of the possibility, and right now, credit spreads are extremely tight, reflecting certainty in a soft landing. If the soft landing becomes a hard landing, we think being higher quality will help weather that type of environment. Finally, if your investment mandate allows it, we see value in certain securitized bonds, such as mortgages and asset-backed maturities, given where spread levels are relative to history. But in all, fixed income’s role in an asset allocation is much more relevant today than when rates were sub-1%, particularly for those investors that need income.