What a Fed Pivot Means for Fixed Income

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0:46Talk of a Fed pivot. What does it mean for the bond market? Welcome to Real Vision Daily Briefing. It's Thursday, December 21, 2023. I'm Ash Bennington, joined today by Kathy Jones, Chief Fixed Income Strategist at Charles Schwab. Kathy, welcome to the show. Thanks for having me. Glad to be here. Kathy, I was saying before we went live how fortunate we are to have you with us on our last live show of the year to talk about what's happening in bond markets, which are obviously the center of the universe in financial markets right now. Look, we're at a 22-year high right now on interest rates. inflation still too high.

1:21And yet we have talk right now that the Fed is going to begin this pivot. Kathy, big picture. Where are we? How did we get here? What's your view of what's happening right now? We started out, if you think back a year, we started out with the idea still that this inflation might be transitory or that, you know, certainly wouldn't get as high as it did. And then the Fed had to move quickly and say, oh, wait a minute, we made a mistake. We've got to hike rates. We've got to get inflation down. It might be sticky. It might be persistent. And they came out with all this new terminology and these new studies to show why they had to raise rates significantly.

2:02And so rates shot up, and it really accelerated in the third quarter of last year. As the growth picked up, we'd been kind of bouncing along at relatively low growth rates. And that really picked up in the third quarter, and that got everybody concerned that, oh, we're going to see inflation pick up. The Fed's going to have to tighten even more than they have, even though they stopped raising rates in July. And that got us up to 5%, 502 in 10-year yields, short-term rates pushing up well above 5%. And then I think there was a sort of this awakening that happened in November when inflation started to come down, growth prospects started to turn around.

2:48We had much softer global growth than anticipated. And the picture just shifted really quickly. So here we are now looking at 100 basis points less in yield than where we started just a few months ago. And the Fed pivoting from, oh, we're going to be higher for longer, leave the door open to more rate hikes, to, oh, wait a minute, inflation is falling. We need to start cutting rates to keep pace with the decline in inflation. So we've done a complete 180 in terms of Fed communications. implications, and I think Fed perception of what their path is going to be. Yeah. You know, it's so interesting, Kathy, as you describe it.

3:32There's so many different angles to look at this story from. We could talk about this in terms of the pandemic, this whipsawing that we saw on CPI, depending upon what measure of inflation you're looking at, from nearly zero in the spring of 2020 to nearly 10%. So you see this just unprecedented whipsaw. You've got the cyclical story. You've got the secular story. If we could take a look maybe at the 10-year treasury note yield chart. I think this is interesting. If we look at it on a one-year basis, you can see what you were just talking about, this drift down from about 5 % to where we are today and under 4%, 3.892 on my screen right now on a yield basis, 10-year treasury note.

4:10But then if we zoom the camera out a little bit and we look at the max chart on the 10-year Treasury yield. What you see is the secular story here, which is my entire career in finance. In fact, most people who are watching this in memory, this just steady drift down over a 40-year time period to new lows on the 10-year Treasury yield coming into the quantitative easing and the accommodative monetary policy stance that the Fed took during the pandemic. How do you begin to get your head around that, sort these stories out on multiple time horizons? You know, I would say so. I do remember, I've been doing this for a little over 40 years, so I do remember the great era of inflation and the big shift in the early 80s when inflation started to fall and the subsequent years and years of declining inflation, getting back to what we would probably consider normal 2 % to 3 % or sustainable at 2 % to 3 % and then dipping down during the financial crisis.

5:12So I don't expect that we're going to go back to the 50 basis points that we saw at the low during the pandemic. That was extraordinary. But I do think we're getting back to an era that's perhaps the old normal. In other words, it isn't inevitable that we have to go higher and higher from here. We don't necessarily have the same dynamics that we had in the 70s to push inflation higher. You kind of retrace your steps and you say, well, we had the big fiscal expansion in the late 60s, the guns and butter era of Vietnam and social spending. And then we had the big expansion in inflation in the 70s, partly due to oil prices, the rolling crises, and partly due to mistakes on the part of the Federal Reserve where they didn't get ahead of inflation in the early 70s.

6:11And remember, we also went, you know, we floated the dollar in 1971 under Nixon. And that was a whole different dynamic. The dollar went down and substantially increased import prices along with those oil crises. So to replay that whole story, that doesn't really seem very likely to me. That was a unique set of circumstances. And this Fed has really kind of targeted not doing that right. We know Volcker was a hero or has been a hero to Jay Powell, who has his book on his desk to show that they're going to stay at it. So I don't think we're going back to that era of very, very high inflation. But I do think, look, you know, bond yields, even if we hit the Fed's 2.5 % inflation target, you typically see bond yields, say, 10-year yields would be 1.5 % to 2 % above that.

7:10So, you know, roughly around 4 % is not an unusual kind of or an abnormal valuation for treasury yields at this stage of the game. So I think we're just getting back to the old normal, if there's ever a normal or an old equilibrium that kind of makes sense. Well, it's so interesting. You talk about the story, the lessons learned from the Volcker era. Nobody wants to be called Arthur Burns if you're in that chair at the Eccles building. But it's interesting to see when you talk about this sort of unique chain of events that we saw in the 1970s and 80s. I think it was the peak on 10-year Treasury yields was during, I think it was the first year of President Reagan's first term, 1981, getting up near 16 percent and then drifting down, as you said, to about 50 basis points in 2020 during the pandemic.

7:58You mentioned this idea of Treasury yields around 4 percent. Boy, it's been a long time since we've been there, 2007 or so. But that's the glide path that you see headed back to approximately the 4 % range on a longer-term basis? I think so. Again, I don't think that it's reasonable to forecast stable yields. The economy is not a stable thing. It has its ups and downs. There's a lot of dynamics right now that involve the global economy. But when I look at where we are the next 12 months or so, I think 4 %-ish is not out of the question. We could drift a bit lower. The global economy is soft. And the dynamic on inflation is that it's falling.

8:44And the Fed's still tight. We still have short-term rates over 5 % while we have falling inflation. We still have pretty high real interest rates at a time when the economy is slowing down. And then you have quantitative tightening still taking place in the background. And the rest of the major central banks look a little behind the curve in terms of what they're doing, maybe intentionally so. But when we look at where Europe is and the UK is in particular, they're allowing their economies to really tip into recession likely in order to get inflation down. So that dynamic globally will probably lead us to lower rather than higher yields in 2024.

9:31We're going to take a quick break and be right back with more of the day's top analysis on the Real Vision daily briefing.

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10:41How hard do you think the Fed is going to struggle to get inflation, like, for example, CPI around 3%, down to the 2 % target? One of the questions I think that people have is, you know, inflation, of course, is a rate. We talk about it as a rate. But if you think about something like a rate like speed, what matters is speed, rate, plus time. And, you know, when you have sustained inflation, if you have a period of inflation that's significantly above the 2 % target, the Fed targets PCE. But for the sake of argument, it's pretty similar in terms of rates being tightly correlated. When you have these periods of sustained inflation over time, even if it's running at 3%, this can mean real pain for consumers, real potential economic challenges for individuals, for households, for investors as well.

11:25How hard do you think the Fed is going to struggle or worry about that 100 basis point spread between their target and about where we sit now? Well, I think they're very much determined to get inflation down to 2 %-ish. And when you look at core PCE right now, in the third quarter, it hit 2%. And on a rolling six-month basis or annualized six-month basis, it's at 2 % already. So I think that the Fed is recognizing that this is painful. One of the things that I love to do, which shows just how nerdy my life is, but one of the things I love to do is read the commentary from the regional Fed banks.

12:07They do a survey every quarter, mostly focus on their businesses. And when you look into the comments, they have an index that will come out. But when you look into the comments, you really get the sort of nitty gritty of what businesses are telling the regional Fed presidents. And that often informs the way they lean. And I noticed this particularly with Atlanta Fed President Rafael Bostic earlier in the year. He was one of the early ones to say, maybe we don't need to keep hiking rates. We're seeing slower growth on the horizon and less of the way of pressure on prices. And you could see that from the commentary from the businesses in the regions.

12:49They were saying, our big concern for the last two years was inflation. Now it's a slowdown in orders. Now it's the demand side that's affecting us. And the cost of financing is really stressing consumers. it's really starting to stress their ability to build inventory and to run operations. And so, you know, I think that's what the Fed is responding to, is that sort of atmospheric change that's taken place in their regions and they have to address because it is very painful for consumers. Either there's the pain of inflation or the pain of high financing rates when you try to buy a car, get a mortgage or use your credit card.

13:29So they're balancing that. But I think there's a recognition now they're getting on the other side of this. And the financing costs are inflicting pain on consumers and businesses. Kathy, since you bring up the regional Fed, how much regional dispersion do you see across the Federal Reserve districts in terms of the level of inflation? Do you see any sort of isolated pockets where inflation is either more severe or less severe than others? Or the sort of the balance of terror between fears about growth and fears about inflation sort of sort out in different ways? or is it pretty homogeneous? Yeah, it sorts out in different ways, I would say.

14:04I mean, you see these bumps in inflation, say the West held out longer than the Northeast. So when you read the New York and the Philadelphia, it looked like things slowed down much faster than they did in the West. But now the West is slowing down. The Southeast, you'd see that the housing component was still very strong for quite some time, but other businesses started to flounder. You see in Texas, which is an economy unto itself and a world unto itself when it comes to those Fed commentary, what you see on the Dallas Fed is, of course, energy sustained it for a long time when energy started to slow down.

14:44Then you saw the ripple effect with commercial real estate starting to slow down and housing started to slow down. So it's kind of a rolling wave and it pops from one place or another, like you're popping popcorn, you know, might be up in one region and down another. But in general, when you look at it in aggregate, we've gone from where inflation was really the problem and labor shortages to, oh, uh-oh, financing costs are a problem and demand is getting to be a problem. Yeah. So you mentioned earlier that your call, Schwab's, calls for three 25 basis point cuts next year beginning in May. Talk a little bit about how you see that unfolding and what some of the potential risks to that thesis could be.

15:25Yeah. So, you know, we've been tempted to increase that to four after the Fed meeting, just based on Paul's commentary being so dovish. But we're sticking with that because I do think there's enough resistance from some of the other Fed members to moving too quickly. There's still this lingering fear that we'll get a reacceleration inflation. And you hear that from Williams and the New York Fed and a couple of other people who've spoken up. So we're going to stick with May, a mid-year pivot to cutting rates and a gradual pivot. And only three, although I think I'd have to leave the door open to four, because once the Fed gets going, they tend to keep going on a regular basis.

16:11But the thesis is based on the idea that we will see this deceleration inflation playing out. Rents will have to come down. That's a big component of it. We might see some increases in other areas that have been pulling the inflation numbers down, maybe on the durable goods side, but it really gone down sharply. But, you know, evening out as we see rents come down and the Fed kind of being comfortable about mid-year that it's safe to go ahead and start talking about lowering rates. If we're right on that thesis, then they'll continue kind of on a steady pace. But I do think they're spooked enough.

16:52I don't know. This is a very, it's been a big pivot in Fed communications. So on the one hand, they were very backward looking and cautious. And then all of a sudden they're forward looking and not so cautious. But we'll have to see how the numbers play out. But my guess is that by May, they should be pretty comfortable with the idea that it's okay to start lowering rates at least modestly and gradually. You mentioned the distinction between core and headline inflation. What do you see being a factor, if any factor, from food and energy prices in 2024? Well, they have been coming down, fortunately.

17:30Energy is always a tough one to forecast because you have OPEC and OPEC Plus and now OPEC Minus Angola, I guess. So it is really tough to know how they're going to, when a price is kind of set by a cartel or cartels, it's really difficult to forecast. But I think the lesson we learned over the last year is there was a lot of supply. I think the biggest surprise for a lot of forecasters in the commodity markets, and that's where I started my career, is that oil prices, instead of going to$150 or$200 a barrel, actually collapsed back down in the 60s. So I'm going to guess that, you know, we're guessing that the trend is for moderate but more stable energy prices.

18:17Food prices, a lot obviously depends on weather and trade. One thing we're monitoring is the trade problems we have because of the blockage in the Suez Canal, what that does to freight rates, what that might do to shipping. But in general, food prices look like they're not going to be a big contributor to inflation in 2024. Yeah, the geopolitical issues, particularly around oil, are always a wild card there. And obviously, as we've seen some potential geopolitical risks in the Middle East, particularly around the Suez Canal, becoming a factor, something to certainly keep an eye on. You also mentioned quantitative tightening.

18:54I want to talk about this a little bit. I'm looking right now at a chart of total assets minus consolidations on the Fed balance sheet. We peaked, I guess, in 2022, close to$9 trillion. We're now at around$7.7 trillion. So significant roll-off, but still massively elevated from the pre-2008 period, where we were at about$880 billion of total assets on the Fed balance sheet. So a massive expansion, more than 8x, not just from trough to peak, but also from where we are at current. What's your perspective on the Fed's role in easing off that balance sheet? We know that the Fed is very uncomfortable with the large balance sheet.

19:36It's a political problem. It looks bad. They're used to remitting funds to the Treasury instead of needing funds to come back to them for operations. It's not a problem for the economy, but it's a problem for the Fed to manage. They're uncomfortable with the high level of the mortgage-backed securities that they hold. They'd like to be out of the housing business and reduce those holdings. That's obviously been tricky lately. So we know that that's the direction they want to move. They haven't really said, well, here's the optimal size that we want the balance sheet to be. It's been suggested by a couple of Fed officials that it should maybe settle around 20-25 % of GDP, which would roughly put it in the$4-5 trillion area.

20:30So there's more work to be done to bring it down. The Fed seems comfortable with the idea that they can run this shrinking in the background without affecting the economy, without affecting the financial markets. I wonder how viable that is. over the long run. But for now, I think that that's the plan. Continue with this gradual drawdown as long as it's not disruptive. We're going to take another quick break and be right back with more of the day's top analysis on the Real Vision Daily Briefing. Alongside brilliant minds like Edward Snowden, Benedict Evans, and Balaji, I'll be on stage exploring the extraordinary potential of AI and the profound change it represents, not just for financial markets, but also for the world as we know it.

21:17With over 5 ,000 attendees and over 150 side events, Singapore will become a vibrant hub for a full week from the 3rd to the 9th of June. Visit superai.com to register and join me with 20 % off tickets with the code REALVISION. Link in the description. What's the risk there? What does disruptive look like? I'm assuming that's a tightening in financial conditions. How might that play out? How would we know if they were tightening too fast? Yeah, well, you remember back in March, we had a real crunch in the financing markets because there just weren't enough reserves in the system. And that would be the problem that we would face.

22:00Now, having said that, there's still a lot of money in the repo market, the reverse repo program that shouldn't be a problem to keep that going. But I think that that would be the concern that the Fed has, that you reach a pinch point again and they have to come back in and provide reserves to the system. I worry about a little bit more from a communications and signaling point of view. So if you think back to quantitative easing, every time the Fed started that, the yield curve steepened and long-term rates actually went up. because the signal that they were sending is that they're stimulating the economy, adding money to the economy or adding reserves to the financial system.

22:45Quantitative tightening has had the opposite effect. It's tended to make the curve flatter or inverted. So on the one hand, if you say, well, we're tightening, you know, through quantitative tightening, that's foot on the brake, but then we're going to ease policy because rates are too high. so that's a foot on the gas, you're kind of sending a mixed signal to the market. And that, you know, it's hard to drive with one foot on the gas and one foot on the brake. So I don't know how the market's going to interpret this going forward. Yeah, there really are just a lot of different policy actions moving in different directions at the same time.

23:25And you try and sort of titrate the balance of all of those. The other thing, when you mentioned the repo markets, I mean, one of the challenges, it seems with financing markets is that everything is fine until it's not, right? It's just like this pivot point, right? I mean, I remember back and I guess it was the fall of 2019 when we had the seizing up in the repo markets and you had the secure overnight financing rate blowing up. I mean, it just happens very quickly. And I guess that's certainly got to be a challenge that the Fed has to be worried about. Yeah. And I know that they're monitoring it very closely.

23:56They've put in place certain tools that they can use, just like with the bank term funding program, when the banking system crunched up, they have tools in place now and there is money can be deployed. But obviously, if you're at the Fed, you want to avoid getting to that crunch point, right? You don't want to push it to the point where, oh boy, here comes another program, pull out the toolbox, let's do something. You don't want to cause that disruption. So I'm quite certain that they're monitoring very quickly or very closely and want to take preemptive action if something develops. But so far, so good.

24:33We'll see how it works out. But I do worry a little bit. I'm not as convinced, I think, as a lot of people at the Fed that this tightening, easing simultaneously is really a viable strategy. Kathy, we've got a lot of questions coming in to us from our viewers and their good ones. First one comes to us from Philip Treese from the Real Vision website. Kathy noted that the Fed is still tight, but based upon liquidity, is the Fed not still loose? Well, liquidity, it's kind of a loaded, it's a word that's loaded with many meanings, right? So people will look at various ways to look at liquidity. I tend to look at it as, you know, is liquidity really ample?

25:20It seems to be in the financial markets, seems to be plenty of money sloshing around. On the other hand, the cost of capital is very high. Banks are tightening lending standards. And that tends to be a form of tightening. And real interest rates are very high, the highest they've been since 2008. So So it depends on how you're going to measure liquidity. I would say it's not tight, but it is tightening. In other words, if the availability of credit is declining, if the cost of credit is rising, if the real interest rates are rising, I'd say that's all on the tightening side and offsetting the liquidity that might be still sloshing around.

26:10Here's a question from Ralph Humphrey, one of our regular viewers from the Real Vision website. What a substantial increase in crude oil challenge her rate cut outlook. Yeah, the problem with oil price increases, particularly oil price shock, is it's both inflationary and deflationary at the same time. So it's inflationary, obviously, on the top line because it sends up CPI particularly. But on the other hand, it's a tax on consumption, whether it's individuals or trying to fill up their tanks of gas or companies who are using energy and energy-related products. So it's not typical that the Fed responds to oil price shocks immediately with a change in policy.

26:59I think they would have to see that it was a long-lasting issue that was not offset by a decline in demand. So that would be the calculus the Fed would have to do. I'm not anticipating a big shock in crude oil prices, but I don't necessarily think that that would change the Fed's strategy. Obviously, it just depends on how long it would persist and whether it would have the effect of being like a tax on consumption. Here's a question from AJ Steininger from the Real Vision website. Do you think we could go back to the lows made in October? I think AJ is probably talking about U.S. equity markets.

27:35That's where the S &P bottomed on that cycle. Kathy, I know you're not an equity person. What are your thoughts more generally here on the role that rates could play in other risk asset markets, particularly U.S. equities? Typically, you would see risk assets decline as interest rates go up and vice versa. And I think, you know, our equity folks definitely, you know, see that the prospect of pivoting, the decline in inflation expectations and where Fed policy is going is given new life to the equity market over the last couple of months. So I don't know about going, you know, they don't have a forecast to go back to the lows, particularly what they are really closely monitoring is sort of the shift in leadership from, you know, this very narrow number of large cap stocks, mostly tech sector.