The Market vs the Fed
Strategy
There is an easy way to compare the market’s expectation for the fed funds rate versus the FOMC’s expectation. A rising rate of inflation led to higher interest rates, which ultimately worked its way through to a higher expected fed funds rate. Higher inflation kept pushing up the expected Fed Funds level which fed into Silicon Valley Bank’s failure. Within days of the failure, the yield on the 2-year maturity Treasury note declined by over 100 basis points! This led to a decline in the expectation for the peak Fed Funds Rate from 5.60% to 5.00% in a matter of a few days. It also resulted in the revised outlook for the Fed to cut rates twice before the end of the year. The Fed, however, still believes it needs to raise rates at least one more time this year and then have them remain at the higher level for some time. We have a divergence between the market and the Fed’s outlook for the Fed Funds Rate.
Prior to the recent bank failures, the consensus view among economists was that the economy would have two quarters of negative GDP in 2023. This is despite a robust Q1 GDP. The rapid increase in interest rates would slowly work its way through the economy ultimately causing a slowdown in activity. The bank failures would cause credit to be less readily available, adding to the slowdown in activity. Finally, the passage of time would add to the economic headwinds as monetary policy works with a lag and the more time that passes, the higher the probability of a recession. Bank failures were acting like a catalyst for those who believe a recession is imminent. Time will tell who is right but at this point there is a very wide difference in expectations.
Realistic investors understand they will rarely pick the top in rates or prices. That’s why we have been advising our readers for months to invest now, lock in rates we haven’t seen in years, and keep investing as we expect they will fall to much lower levels. March showed us just how fast expectations can change and how fast interest rates can move. It took 6 months for the yield on the 2-year Treasury note to go from 4% to 5%. It took less than 2 weeks to go from 5% to 4%. Market timing can be a dangerous game, which is why professionals pick an attractive entry point and then keep buying from that point forward. One never knows what exogenous shock can change things drastically and the failure of Silicon Valley Bank was one such shock.
"A mild recession is currently the consensus view."
The recent bank failures resulted in much lower rates as well as increasing the probability of a recession. A mild recession is currently the consensus view. While the FOMC ponders whether to raise rates in May, inflation continues to fall. We have seen the Consumer Price Index (CPI) decline from 9.1% last June to 6.0% in February. The Personal Consumption Expenditures (PCE) likewise declined to 5.0% from a peak of 6.4% last summer. Expectations for both measures by year end are much lower than current levels. In fact, the CPI is estimated to be in the high 2.0% area by the end of the year. Many other economic indicators have weakened recently, such as the ISM indices and the Leading Economic Indicator index. If we see a decline in the jobs data, our guess is that a real slowdown has started, and the Fed should pause for at least a couple of months. Given the lagged nature of monetary policy, let’s hope a mild recession doesn’t become a severe one if the Fed makes yet another policy error.
The path of least resistance seems to involve a “noisy” move toward lower interest rates and softening economic activity. Uncertainty caused by a prolonged Fed pause, faced with whiffs of inflation and a gradual slide toward negative economic data, will cause volatility in both investor sentiment and interest rates. Expect volatility to extend to risk spreads as the Federal Reserve fights inflation with higher short-term rates and a resumption of the Quantitative Tightening activities. The power of the “pause” in policy will be the Fed’s most relied upon tool in 2023. Economic activity will comply with the Fed’s wishes as calls for the Fed to “listen to the market” because they are going to “kill this economy” will go largely unanswered because that’s the whole point, make the market less optimistic. Against the backdrop of spread volatility and declining rates, high-grade corporates, taxable municipal bonds, agency commercial mortgage-backed securities, shorter average-life and tight window Collateralized Mortgage Obligations, and both Treasuries and agencies should see strong performance as compared to other sectors.
What should investors do in an environment of slower growth leading to a possible recession, falling inflation, and lower interest rates? Total returns in the first quarter were very good. Most fixed income indices advanced 1% - 4%. We still have yields that in some cases are the highest they have been in 15 years. The advice we provided last quarter has worked extremely well and we continue to believe it will work in this quarter. That would indicate to us that buying longer term maturities (based on your maturity range) continues to make sense. It seems much more likely that rates will fall versus migrate back to the recent highs. Call protection is paramount in this environment. Don’t get enticed by a slightly higher yield attached to a call feature. If you buy mortgage-backed securities, buy discounts which provide natural call protection. Lastly, given the increasing likelihood of a recession, higher quality securities are preferred over lower quality ones. Credit spreads, for example, will widen in a recession so leaning towards higher quality is prudent at this time.
"Modern Monetary Theory never quite passed the smell test."
Longer-term, although we subscribe to the idea that developed countries are poised for disappointing levels of growth, we have some structural risks that could take us down the path of stagflation. If the hegemony of the U.S. dollar is called into question, our ability to print money to solve economic softness could be a part of our “golden” history. Massive amounts of recent past malinvestment resulted in accelerating consumption and granted us a debt burden that will haunt us for generations to come. A common theme for developed countries is that older populations save more, and they also hold a belief that older workers are less productive, so with the dampened velocity of money and lower corporate return on capital, interest rates will fall as well. Since average and median saving rates for all cohorts is dismal in the U.S., presumably government will need to borrow more money to pay for the needs of aging populations. The crowding out theory of economics would suggest that in the longer term there would be bias toward higher borrowing costs. Intuitively the more an entity borrows, the more it will incrementally cost to borrow. Modern Monetary Theory never quite passed the smell test. At a point free money is a fantasy and the reality of investors caring about both the return on and of their money has got to return both investor and borrower expectations back to a state of sanity.
In taxable portfolios, we continue to encourage a barbell strategy (some exposure short and some long), with an emphasis on quality, and limited optionality/callability. Although the curve inversion has diminished, short rates around the 1-year to the 2-year area are high and we expect the long end will see yields fall in a way that contributes to portfolio returns. Our municipal strategy involves waiting to see if credit fears take longer muni yields higher. Bond portfolio management can feel like being a punter on a professional football team, constant intensity in reading the field with fleeting moments that are make or break to the success of the team. It feels like for the first half of the second quarter of 2023, we will be watching intently from the sidelines.
Observations and Outlook – Consumer or Credit, We Think Credit
It is tough to know if institutions will pull away from risk first or if a crack in the strength of the consumer will cause the aversion to risk. Our best guess is that increased borrowing costs, along with manufacturing inefficiencies caused by the reversal of the current makeup of the global supply chain, and a profitability recession, will lead institutions to diminish risk appetites. Ever the optimist, U.S. consumers are slow to desire changes to their buying habits. Although the consumer may be the key to getting inflation expectations down on a sustained and less traumatic basis, we don’t think they will grab the most headlines in 2023. According to the New York Fed Consumer Credit Panel/Equifax, in late February, consumer credit card balances surpassed the pre-pandemic high, with balances totaling $986 million, less than we would have expected, as compared to the total credit limit of roughly $4.5 trillion. In the Great Financial Crisis, extended credit card limits shrunk nearly 40% between 2008 and 2009. The ability for the consumer to continue their current buying habits may be quickly reversed if credit lines are rapidly restricted. Inflation is taking a toll on consumers, who are once again achieving anemic savings rates and building credit card balances. Interestingly, credit card delinquencies are historically low, but appear to be rising at a noticeable rate in 2023. Another sign of impending difficulty for consumers is the pace at which they are falling behind on their auto payments. At the end of 2022, the percentage of subprime auto borrowers who were behind on payments (being at least 60 days late) hit 5.67%. At the peak of the great recession, in January of 2009, the number hit a maximum of 5.04%.
In the minds of individuals, the current sources of pressure won’t be letting up anytime soon. In early April, respondents to a New York Fed survey expected prices to rise by a half a percentage point to an annual gain of 4.75%. They expect gas prices to rise by 4.6% and food prices will be 5.9% higher. Clearly consumers don’t expect a near-term Fed victory against inflation. The Fed survey also brought to light that consumers see their access to credit diminishing. Perhaps it is for cause, 10.9% of respondents expected they would miss a minimum payment over the next year. Finally, the job environment is presenting a more mixed picture. Although unemployment has dropped to 3.5%, the Labor Department’s Job Openings and Labor Turnover Survey (JOLTS) showed that job vacancies at U.S. employers dropped in February to the lowest level since May of 2021 (available jobs were 9.9 million versus 10.6 million a month earlier). The ratio of job openings per job seeker fell from 1.9 to 1.67. Pre-pandemic, that ratio was roughly 1.2 and we think the ratio falls below 1.0 as the Fed’s inflation fighting work concludes. Inside the recent jobs numbers, it may be noteworthy that the new jobs were nearly equally split between services and goods-producing firms, and roughly the same number of jobs lost in the financial activities and professional services sectors were in line with the 98,000 workers gained in the leisure and hospitality sector. We seem to be continuing the trend of replacing higher-wage jobs with lower-wage opportunities. The consumer is showing signs of stress, but our forecast is for a gradual grind lower in terms of the psyche of the economy.
Before we address the largest and most disorderly source of a change in the Fed’s path, we will touch on some self-inflicted wildcard developments that will have unknown effects. Worse yet, some of them may be multiplicative if they were to occur simultaneously or sequentially at an inopportune time. The debt ceiling will likely come to a head at the end of the second quarter or the start of the third quarter. Both major political parties have become polarized to a degree and the risk of a centrist compromise seems more remote than past congresses. The game of “chicken” with the country’s credibility, future financial health, and global standing is both predictable and unacceptable. Massive deficit spending (beyond what was needed to combat Covid) to burdensome levels of national debt (along with underfunded entitlements that make the debt look like child’s play) call into question the viability of the U.S. dollar as the world’s primary reserve currency. To make matters worse, the linkage of the U.S. dollar to energy, the lifeblood of many global economies, has been eroded as oil transactions are now being conducted in other currencies. Erosion of the relationship between the U.S. and Saudi Arabia could expedite the weakening of the U.S. dollar as fewer U.S. dollars will be required for this dominant segment of global trade. A valid question is what happens to all the U.S. dollars if they are no longer needed for oil transactions? Recent weaponization of the SWIFT international payments system (to freeze Russia’s ability to participate in trade and international transactions as punishment for the invasion of Ukraine), may have accelerated the move away from using globalized systems so they are less able to be influenced by world governing bodies and trading blocs against which they compete. For countries against which the U.S. and “the west” compete, using the dominant world reserve currency and a global payment system recently changed from being an annoyance to an exposure to economic warfare. Diminished growth in U.S. energy production has likely elevated OPEC’s influence. It is tough to know if the impetus for the two recent production cuts was increased profitability, projection of dominance, collaboration with global carbon-based fuel reduction goals, or several alternatives. The recent hike seems like it will hit the U.S. as more of an inflationary “tax” in that it will cost consumers more for petroleum-based needs, but it may not offer the broad economic benefits we might see if we were larger producers of energy.
"Forcing lower income people to buy an electric vehicle, even with a $7,500 tax credit, seems somewhat cruel..."
We are certainly for clean energy pursuits, especially if nuclear fusion meets your definition of clean energy, but as we have said in the past, the burden of the change falls on the shoulders of those who can least afford the cost. The average cost of a compact combustion engine car is $26,000, while the average cost of an electric vehicle is $64,000. Forcing lower income people to buy an electric vehicle, even with a $7,500 tax credit, seems somewhat cruel, even if you get there by taking away their choice by ending the supply of combustion engine cars. With all the pressures facing low-income people, it feels like we are corralling some of our neighbors into inescapable cages, with bars of debt, labor market realities, and voting cooperation, all born out of desperation. Corporations and higher-income people won’t likely be unscathed. Just a year after the congress appropriated $80 billion to rebuild the IRS over the next decade, the Biden administration, though Treasury Secretary Yellen announced a request for an additional $14 billion to provide “steady-state operational funding” that will “allow taxpayers the best service possible.” It seems a gold-plated cage, or collection basket, is being built. Is it right to think that it is being built to capture the taxes desired to continue the level of spending and allow for the wishes of the many to be carried by a relative few? According to a 2021 Treasury report, the $80 billion would allow for the hiring of approximately 87,000 IRS employees over the next decade. The expectation from the Congressional Budget Office is that the investment will generate $200 billion in additional tax revenue over the decade, but it will come at the cost of companies having to field IRS inquiries and spending more money on accountants and tax advisors, rather than inventing products, giving raises and bonuses, focusing on customers, and several productive pursuits. Did anyone bother to quantify the cost of audit and inquiry activities when calculating the windfall profits that this might “net?” Most people would like to see tax evaders pay the appropriate amount. This seems like a job for machine learning/artificial intelligence, rather than an army of additional people. The time to build the systems, hire people, and promote the digital U.S. dollar to capture increased levels of tax revenues is ahead of the move toward a higher tax regime.
"What the market may be lulled into believing is that risks in the market away from stocks are settled."
The area that we think has the greatest chance of abruptly changing the trajectory of the economy is a biproduct of declining corporate profits and increased borrowing costs. The recent banking crisis has interest rate risk in the forefront of the market’s mind. Interest rate risk is the risk of market value losses as interest rates rise. The more interest rate risk you assume, the greater the loss for a given increase in interest rates. What the market may be lulled into believing is that risks in the market away from stocks are settled. Over the next couple of years $150 billion of office-related commercial real estate financing must be refinanced. Crowding out that space is the $430 billion in loans and bonds that high-yield corporate borrowers must refinance through 2024. Although Bloomberg’s Junk Index has seen borrowing costs move from roughly 10% in the last quarter of 2022 to approximately 8% in the first quarter of 2023, the current levels are nearly twice what they were two years ago, when borrowing costs were roughly 4%. The zombie companies that were not profitable enough to pay debt service with a 4% cost of borrowing will be in difficult shape if they have to pay 8% in the current market. Often in a recession, credit spreads (the incremental yield for a risky bond as compared to a similar maturity Treasury security) will widen as people abandon risk and flee toward safety. If a recession hits the U.S., it would certainly be possible that junk bond yields could hit 12% with ease. In a related development to the impact of rising borrowing costs, U.S. banks will likely see profits come under pressure. As banks were able to pay depositors very little for the use of their funds, awareness of what is available in the marketplace has spread and banks generally must pay materially more to keep deposits from leaving. At the same time, some banks have pulled back on lending. If banks are paying more for deposits and lending less, profits will very likely be under pressure. With companies increasingly more challenged to find sources of financing through the syndicated loan market, the junk bond market, or the banking system, disorder may occur. As we have suggested in the past, if corporate profits experience their own recession, and borrowing costs make matters worse, we expect both mergers and acquisitions activity and defaults to pick up. There are plenty of looming factors to fuel a frozen credit market or materially wider risk spreads. We expect the impact could weigh heavily on the corporate outlook, hiring plans, profitability, the consumer’s confidence, and potentially even Fed policy.
The market seems to think that because the Fed was nimble in the past, they will necessarily need to be agile at the current time. We think the Fed hopes to be able to mentally grind down economic expectations over time, rather than have to jump in to save the economy. It would likely mean a more orderly decline in the employment environment, less sharp changes in asset values, and fewer tragic stories. ACG’s expectation is that the Fed will raise the Fed Funds Rate by 25 basis points in May and then pause for an extended time. The market has vacillated wildly this year, in terms of its expectations of the top Fed Funds Rate as well as the expectation of the need to cut the rate. As we enter an uncertain phase, where the last anticipated hike is made and inflationary signals are not uniformly positive or negative, we could see a greater probability that the Fed would surprise the market with an additional hike versus the chance of a cut in 2023. That view is based on the soft-landing scenario where the credit crunch does not occur, and global influences import unexpected waves of inflationary pressures to the U.S. If the access and cost of credit doesn’t get out of hand soon, the probability of a Fed rate cut by the end of the year has a short runway to become a reality. The combination of continued Quantitative Tightening efforts and at least one more rate hike, against the backdrop of a profitability recession may result in challenging times for risky assets, while high-quality bonds should see some appreciation over the next year. Yale University economist Robert Shiller has said “there’s never been another time when the economy was already in an earnings recession and the Fed was still in the midst of a significant tightening campaign” and “ideally, the Fed finished its campaign when companies have something left in the tank.” It feels like zombie companies, weak consumers, and even mismanaged governments have very little in the tank to be resilient through a meaningful economic slowdown. Hope for a soft-ish landing and expect something rougher.