At the latest Jackson Hole economic symposium, Fed Chair Powell mentioned that the time has come for policy to adjust. What did you take away from that speech, and what are Madison's expectations for the Fed's next course of action?
My biggest takeaway was that the Fed may be more concerned about the labor market than the other side of its dual mandate, inflation. The employment picture is worsening slightly, and their ability to achieve a soft landing may be more difficult if they don't adjust policy. That’s why I think the next labor market release will be a significant driver in how much of a cut the Fed does in their September meeting.
What should investors expect for rate cuts for the rest of the year, and what does it mean for the back end of the curve and risk assets?
The market is currently pricing in a pretty quick path to a terminal rate of 3% - about nine cuts in total - and a 3% Fed funds rate by the end of 2025. Even more aggressively, four cuts through the end of this year in three meetings. Given the current economic environment and how good the economy seems to be doing, we think that's aggressive. From our perspective, if the Fed is aggressive and delivers those nine cuts, it likely means that the economy is struggling, which would also mean that risk assets would struggle. Where we are right now, in more of a soft landing scenario, it’s hard to imagine the back end of the yield curve moving a lot from here. With the market already pricing in a 3% Fed funds rate, you’d have to have a harder landing for those longer-end yields to move lower. Managing risk becomes very important in this environment, given all the factors moving markets around.
Given the outlook you just described, how should investors think about maximizing yield?
I think investors have to be open and opportunistic with what the market is offering in terms of fixed income. Even though we’ve moved lower in interest rates, some areas within the fixed income market are still attractive. We still like financial corporate bonds, such as regional banks, that offer value given where spreads are. But I think maybe the most important thing about fixed income allocations today and how much risk you want to take is that if you look at a high-quality intermediate fixed income portfolio, yielding 4% to 5%, that's higher than where Fed funds rate likely ends up over the cycle. Even though interest rates have fallen slightly, investors can still own a high-quality fixed income portfolio, reduce their reinvestment risk, and lock in those yields above where the cash will likely pay.
So, how should investors think about active management and fixed income, and what should their expectations be given the current environment?
We believe active management is managing all fixed income risks to maximize opportunities and generate strong risk-adjusted performance. Especially when both rates and spreads are volatile, an active manager will assess where the value is across the market and move a client’s portfolio into areas where they think there is the best opportunity for risk-adjusted performance.
For example, the market was pricing in six to seven interest rate cuts earlier this year. We didn’t think that would happen, so we kept durations short relative to the benchmark in client portfolios. Interest rates rose throughout the year as better data came out, and in May, we thought there was an opportunity to push durations out and lock in those higher yields with the longer maturity bonds.
The market thought the Fed funds rate would be closer to 4%, compared to the 3% we thought it would be closer to. The market is constantly changing, spreads are always changing, and rates are always changing. It’s up to active managers like ourselves to find and take advantage of those opportunities.