US Interest Rates and the “New Normal”
What happened last week?
The S&P 500, Nasdaq and Dow rebounded on Friday to finish the week up by 0.55%, 1.43% and 1.14%, respectively.
April’s jobs report pointed to a cooling labor market that could allow the Fed to lower rates later in the year. It showed 175K jobs were created, fewer than expected, and those jobs were concentrated in noncyclical areas like healthcare, education, and government.
3 Things to Know
Investors Shouldn’t Worry About Timing Fed Cuts
The Fed concluded early in 2024 that it could unwind a portion of its extreme monetary policy tightening actions and help achieve an uninterrupted economic expansion during the next two and a half years.
Such predictions can’t properly account for any unknowable shocks that might interrupt the economy. But we wholeheartedly agree with the Fed’s basic premise. As mentioned, monetary policy tightening, COVID-era supply constraints easing, and moderation of wild demand swings are all contributing to a gradual slowing in inflation.
The very similar rise and fall in inflation across the globe points to common, severe, but mostly temporary factors. There seems to be much less divergence between US and European inflation readings than meets the eye.
Of course, if demand in the US were to persistently outstrip supply for goods and services, the Fed could be forced to hold to a restrictive monetary policy for longer or even resume tightening.
As a base case, however, we continue to believe the Fed will be able to begin partially unwinding the sharp tightening steps that culminated in a 5.5% Fed Funds rate later this year.
The Real Concern Remains Bond Yields
More important than short-term views is what to expect from the average US policy rate in the years to come. This “neutral” rate is the rate generally consistent with economic stability.
We believe the Fed Funds rate will be closer to norms from before the Global Financial Crisis (GFC) of 2008/2009, rather than the ultra-low period that followed, particularly the “zero” of 2021 and negative nominal yields of some other developed market central banks.
“Normal” is neither the historical aberration of 1980 (double-digit interest rates after a decade of accelerating inflation) nor 2020 (zero or negative policy rates).
It’s a rate that should “average in” periods of recession (and early recovery) when the Fed is unusually accommodative. The Fed now estimates this “longer run” average rate at 2.6%.
In our view, in a future recession of historic average magnitude, the US policy rate could fall to 2% rather than 0%. Many investors anchor expectations to the two most recent recessions – a pandemic and an intense banking crisis –which were particularly severe and required unconventional government stimulus.
With rates less likely to fall to 0% in the next recession, the longer-run average interest rate could be at least 3.0%. This points to long-term US Treasury yields having reasonable value above 4.0%.
However, the actual rate will vary from this and perhaps for a significant period of time.
FI Asset Allocation: Greatest Value in Intermediate-Duration Bonds
While yield levels may not drop quickly and offer a large “snap higher” in bond prices, current income is higher and we expect that reinvesting fixed income proceeds will deliver a stronger and more consistent income in the future.
We continue to advocate maintaining duration around 4-5 years for overall fixed income portfolios. US Investment Grade (IG) credit spreads remain very tight, about 80 basis points currently.
While this spread is low, it is still incremental yield in addition to Treasury yields, and thus provides some additional income for core fixed income holdings.
We also suggest that suitable clients should consider low BBB-rated and BB (high yield) corporate bonds, where one can potentially earn additional spread over the intermediate IG corporate index. We are also particularly constructive on “structured credit” for suitable and qualified investors.
This includes Agency AAA-rated mortgage-backed securities (MBS) which are currently offering yields in excess of the corporate IG index.
Finally, suitable investors may want to consider an allocation to IG preferred securities. Yields for these IG securities are currently slightly higher than the BB-rated high yield index.
Additionally, depending on structure, many of the US-based preferred issues’ interest distributions are taxed as dividend income, which can have a preferential tax rate for certain US taxpayers, and so potentially increases the pre-tax equivalent yield.
See our weekly CIO Strategy Bulletin for more details