Waiting for the Window to Cut Interest Rates
Core bonds ended the second quarter unchanged and are down 0.7% year-to-date. Corporate bonds barely outperformed Treasuries in the quarter but given a strong first quarter are up 116 basis points year- to-date. Mortgage-backed securities (MBS) slightly underperformed Treasuries in the quarter and have underperformed by 57 basis points in the first two quarters. However, things may be shifting as mortgage-backed securities outperformed corporate bonds by more than 65 basis points in June.
The 10-year Treasury ended the quarter at 4.40%, which is almost exactly in the middle of the one-year range of 3.75% to 4.99%. Potential Federal Open Market Committee (FOMC) rate cuts have been the headline story on many days over the last quarter, but so far, the market continues to push out the starting point. Bonds appear to be in a big trading range until we get more decisive action on a Fed policy path. This has become increasingly more difficult as the Fed becomes too focused on reacting to near-term economic data.
The FOMC believe they are restrictive and that inflation will come down over time. Members again increased their inflation forecasts for 2024 and 2025 in the June dot plot, while simultaneously forecasting a lower Fed Funds target. The FOMC now sees inflation returning to 2% in 2026, which would be a full five years since it became a problem. The CPI is now a cumulative 13% above where it would be if the 2009- 2019 CPI trend were maintained. The Fed rhetoric has also sounded more dovish in the sense that their reaction function to weaker growth or rising unemployment is to cut quickly at any sign of weakness. We haven’t had such weakness, so they are maintaining a hold posture.
Portfolio Positioning
It is becoming more likely that policy is not restrictive given that nominal GDP continues to come in the 6% range and yet the 10-year Treasury is only 4.5%. Neither the Fed Funds rate nor the key Treasury benchmark has been above nominal GDP for a sustained period. Historically, this is what has been needed to slow the economy unless the deficit was shrinking in a significant way. The wealth effect is also being under appreciated this cycle.
The Fed will likely get a chance to cut rates this year on a growth scare or equity market drawdown. The Citigroup Economic Surprise Index is at -30, its lowest level in two years. An interest rate cut is likely to ease financial conditions via bond and equity prices moving higher which has had direct feedback into economic growth two to three quarters forward over the last four years. If the Fed were to cut into only a modest growth slowdown, we could very well see some version of the 1970s repeat.
The portfolios are neutral on duration to slightly underweight. There is a potential that 10-year Treasury rates could fall 50-100 basis points as an interest rate cut becomes a green light.
The portfolios are at near their minimum credit exposure, which is around the neutral level versus the benchmark. During the quarter, we have moved MBS in its largest overweight in at least five years. MBS spreads versus corporates remain attractive.
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