Howard Marks has long been one of the most influential thought leaders to me throughout my career. One of his analogies always top of mind is that of the market swinging on a pendulum. As much as things evolve in financial markets, we haven’t yet escaped the perpetual cycles of the market pendulum swinging from optimism to pessimism. While stocks may be the most commonly considered market, this pendulum effect is ubiquitous across all financial markets, including stocks, bonds, commodities, and more. Lately, the pendulum action has been particularly pronounced in markets trading interest rate instruments.
The swinging action since the bottom last Oct
The fixed income pendulum in fixed income markets remained in full force through much of the last 2 years and reached a point of max pessimism last fall. Maximum pessimism refers to market participants selling assets in anticipation of additional Federal Reserve interest rate hikes, leading to downward pressure on prices and upward movement in yield. Federal Reserve rate hikes are adjustments made to the Federal Funds rate, which serves as the benchmark for overnight interbank lending rates. In turn, this rate will become a reference point for fixed income instruments, a concept for which we’ll soon dive deeper. You can see the pessimism manifested in yields for the 2-year US treasury note (purple on chart below) which peaked in October near 5.2%. Then, the pendulum pinged off the pessimism end and rocketed back to the optimism end as the Fed pivoted from a regime of rate hikes and opened the door for cuts beginning in 2024. The shift was fast and dramatic, persisting into the early parts of this year as investors in rate markets continued to price in more and more cuts. At one point, a total of 7 cuts for 2024 were priced in by rate traders. It was here the 2-year note bottomed out at 4.1%, having fallen over 100 basis points (or 1%) in just a few short months. Just how aggressive and optimistic was that take? The Fed’s pivot and indication was just 3 cuts for 2024.
For nimble investors, this divergence offered opportunities for adjustment, with the big question we were asking as the pendulum swung into full optimistic mode being just how tethered we wanted to be to securities requiring 3-4 more cuts than the Fed had forecasted to be a good deal. To clarify the concept of tethering (especially since it’s not an official industry term by any stretch), I’ll take a minute to explain so we can use it as a simple framework to discuss market navigation.
Bonds Tethered to Fed Rates: Understanding Degrees of Constraint
Think of each category as representing a different degree of “tethering” to Federal Reserve policy. The Fed establishes a target for the overnight rate banks charge for lending out their excess reserves, which becomes a key reference point for financial markets. For simplicity, we’ll categorize investments into three types based on their relationship to this reference rate: handcuffed, leashed, and loosely tethered.
Handcuffed: In financial markets, some investments are akin to prisoners, tightly bound to the Fed’s target rate like inmates under watchful eyes. Money market funds, very short-term (1 year or less) treasury bills, and instruments with fluctuating variable rates fall into this category, where any attempt to stray is met with restraints.
Leashed: Moving along the continuum, other investments resemble leashed pets, enjoying a degree of freedom, but with limits enforced by their proximity to the Fed’s target rate. Short-term (2-5 year) bonds squarely fit this bill.
Loosely tethered: Finally, imagine longer-term bonds (10-30 years until maturity) as tethered astronauts floating in space. While they enjoy greater mobility compared to their short-term counterparts and may even chart their own course, diverging from the forecasted trajectory of Fed rates, there’s still a reference point tying them to the Fed’s policies.
This foundation will guide us as we evaluate the current dynamics in economic data, bond values, and portfolio positioning.
Untethering Leads to Opportunities
In most markets, it’s important to remember that prices can diverge significantly from what may be considered “fair value” or sound reference points. These concepts may vary for each investor. Whether it’s price-to-earnings ratios for stocks or the Federal Reserve Funds’ current rate and forward-looking Fed forecast for fixed income markets, these benchmarks can guide investor decisions. Let’s delve deeper into this in just a moment.
For example, in the stock market, optimism may drive prices higher as investors anticipate earnings exceeding current analyst expectations. This forward-looking nature of stocks means prices can continue rising even if official earnings forecasts remain unchanged. However, this dynamic is less common in high-quality fixed income investments—especially for handcuffed categories and to a significant extent for leashed short-term bonds and notes.
This is where the opportunity lies: adjusting portfolio positioning as our data intake and viewpoint diverge from the market’s pendulum swing. The rapid 1%+ drop in 2-year yields to its bottom of 4.1% (as shown in the chart above) is typically reserved for unexpected shocks. Investors heavily invested in these instruments needed near-perfect conditions to justify the 4.1% rate, leaving little room for error compared to less volatile instruments offering higher interest rates. Nimble investors seized this opportunity by capitalizing on the price increase and transitioning to shorter-dated maturity instruments with higher yields and less volatility.
As expected, data emerged to temper the optimistic swing in the market pendulum, leading to a shift in direction—a trend that continues today (February 22, 2024).”
This version maintains the assumed familiarity of readers with financial concepts while addressing the suggested revisions.
Strong Data
Robust economic indicators, such as strong payroll figures and sustained low unemployment rates, alongside unexpectedly firm inflation, have been pivotal in triggering reversals in market sentiment. The decline in inflation figures, as illustrated in the chart below, served as a catalyst for the Fed’s initial pivot. It’s unsurprising that any deviations from anticipated data would provoke significant market reactions. Notably, the chart depicts a downward trend characterized by lower highs and lower lows, emphasizing its significance. However, there’s also a noticeable uptick at the start of this year, prompting market reassessment.
Crucially, we must acknowledge the impact of shelter costs, a primary component of inflation readings, particularly in the core index. Softening rents, while not immediately reflected in official data, could introduce a notable lag, influencing our positioning framework as we navigate market dynamics.
Importance of Inflation in Fed Outlook
Understanding the foundation for interest rates begins with the Fed’s pursuit of either restrictive (tight), easy (loose), or neutral policies at any given time. The clearest indicator of which policy stance they are adopting is the positioning of their Federal Funds rate relative to the natural rate of interest, often denoted as R*. All these rates are evaluated in terms of real rates, which account for inflation. Put simply, if the Fed perceives the natural rate to be 1%, we might observe a 1% real rate alongside a 5% nominal rate and a 4% inflation rate, or a 3% nominal rate and a 2% inflation rate. Their policy stance—tight or loose—is then determined based on these real rates. Currently, the situation reflects a need for restrictive policy.
Presently, the federal funds rate stands at 5.3%, where it has remained since August 2023. Fed Chair Powell has indicated their preferred inflation measurement as the 1-year expected inflation rate. Last August, when the rate was last hiked to 5.3%, the 1-year expected inflation rate was 2.6%, resulting in a real rate of 2.7% (5.3% – 2.6%). This placed monetary policy at the desired level of restrictiveness, nearly 200 basis points or 2% above its 0.5% natural rate or R*.
The prospect of rate cuts emerged as months of declining inflation data filtered through the system, lowering the 1-year expected inflation rate. This decline pushed real rates even higher from where the hiking campaign paused, effectively surpassing the levels observed when hiking ceased. A visual representation provides a clearer illustration:
What will be crucial for all markets in the coming weeks to months is whether the firmness in inflation data over the last couple of months begins to wane and rolls over, indicating a continuation of the overall downtrend in inflation data. Additionally, it’s important to monitor whether this trend begins to influence readings for the 1-year expected inflation data series closely monitored by the Fed.
A significant consideration for those on the pessimistic side is the potential that the Fed’s estimation of R* is too low. This discussion is legitimate and will be a key aspect of our ongoing analysis. If R* were 75 basis points, or 0.75% higher than their 0.5% estimate, it would offset the decline in the 1-year inflation reading and negate the basis for rate cuts.
To recap and summarize:
- With the economy on solid footing and at full employment (the other half of the Fed’s mandate), inflation remains a primary focus, with current levels still well above their target of 2%. Few would question the need to maintain tight policy to bring inflation back to 2%.
- While inflation remains above 2%, the primary trend for inflation prints has been downward. As long as this trend continues, the Fed will likely need to lower policy rates simply to maintain their desired and elevated level of real rates.
- The market eagerly embraced the narrative of rate cuts, not only factoring in the initial decline in inflation readings but also projecting a swift return to the target rate of 2% for inflation. However, this extrapolation was likely overdone as optimism swung back full force.
- The January inflation data released mid-February acted as a reality check, causing Mr. Market to reassess and swing back from optimism. Projected rate cuts have been scaled back, and the 2-year note yield has bounced back from its low of 4.1% to 4.6% at the time of this writing.
Fair Value
This may seem like a lackluster conclusion to such a lengthy post, but even seemingly mundane insights have significant implications for portfolio positioning. In my estimation, the market pendulum for pricing in Fed policy is currently near the middle after reaching its optimistic peak and beginning its journey back. This places “leashed fixed income” instruments around fair value. For instance, the 4.6% yield on 2-year notes aligns closely with the Fed’s projection for the fed funds rate next year. Considering a couple of years of tight monetary policy, it’s reasonable to anticipate that inflation could be much closer to the 2% target in the future, allowing the Fed to further cut rates and alleviate tightness. This places the 4.6% yield between the current 5.3% policy rate and the 3.8% rate that would reflect two years with 0.75% worth of cuts each.
This forms part of the rationale behind viewing the purchase of 2–5-year notes at current prices as a fair deal compared to remaining invested in shorter-term rate vehicles. However, this assessment has fewer implications for those invested in loosely tethered longer-term bonds. Their yields are subject to greater freedom, capable of diverging or even trending upward while their shorter-term counterparts decline. I’ll delve further into this when discussing portfolio positioning shortly. Several factors contribute to this conclusion, but I’ll highlight a couple. The term premium is likely to increase, rewarding long-term bond holders with higher interest income for the greater risks taken. Additionally, an aging population drawing on their savings, coupled with the government’s increasing need for borrowing to fund budget deficits, further complicates the landscape. Despite the abstract nature of these concepts and estimates, our task remains to align with the factors the Fed considers and adjusts policy accordingly.
Thus far, our analysis of Fed policy and investment strategies among instruments “tethered” to such policy has been largely mechanical and mathematical. However, it’s essential to recognize that there’s more at stake beyond this dual mandate when assessing the pendulum swing.
Desire to Avoid Future Regret
Foremost on Powell and Co.’s agenda is avoiding a repetition of the mistakes made by the Arthur Burns-led Fed in the early 1970s. Pulling back on monetary tightening too soon in the battle to restore inflation to normal levels could jeopardize their credibility. A central bank without credibility wields less-effective tools, akin to wielding a hammer without a head. This concern has been central as the market confidently backs away from previously optimistic rate cut projections, indicating a shift in sentiment.
However, it’s increasingly evident that they also wish to avoid historical patterns of holding rates too high for too long until repercussions arise. Real yield analysis highlights the current tightness of monetary policy, while the yield curve indicator, showing the difference between 10-year and 2-year yields, has been inverted for 18 months—a sign of concern shared by both the Fed and market participants.
This relationship between short- and long-term rates reveals the incentives within the banking system. As banks borrow at short-term rates and lend at long-term rates, prolonged periods of higher borrowing costs and lower lending returns incentivize banks to restrict lending. This banking tightness plays a role in cooling inflationary pressures but historically takes time to manifest fully, often with unforeseen consequences.
On Their Radar
Although the catalyst for trouble typically emerges unexpectedly, the Fed undoubtedly has its eye on the commercial real estate (CRE) sector. With office space particularly hard hit, upcoming loan refinancing poses a challenge, especially under a tight monetary policy regime. Concerns extend beyond office space, but it’s crucial to note that CRE encompasses various categories, each with its own fundamentals. However, lingering concerns among lenders remain a factor in the Fed’s risk assessment, as confirmed by their recent January meeting minutes.
Positioning and Summary
Despite the seemingly benign conclusion that we’re at a more balanced status and nearing fair value for many rate-sensitive investments, there are implications for nimble investors. Adjusting to the market’s oscillations between optimism and pessimism offers opportunities for yield and risk management. Recent adjustments in our portfolio reflect this balanced outlook, with reduced exposure to rates closely tied to Fed policy. This shift is significant after years of maintaining a low-volatility stance.
Furthermore, it’s essential to differentiate among fixed income categories, with a preference for holding shorter-term notes over longer-term bonds due to looming risks in the CRE sector. While the management of overall market sensitivity is a broader topic for discussion, the availability of ETF tools allows for more precise positioning without overexposure to longer-term bonds.
In conclusion, we remain flexible, ready to adjust our strategy as the story unfolds further.