ESGB - Why Markets Are Starting To Rein In The Potential Timing For Rate Cuts
2024-01-19 01:55:00 ET
Summary
- Is sticky inflation challenging the rate cut story?
- Outlook for fixed income.
- Why a March rate cut by the Fed is looking less likely.
Markets appear to be taking a sober second look at when the U.S. Federal Reserve may be ready to start cutting interest rates, with March looking increasingly less likely. Scott Colbourne, Head of Active Fixed Income at TD Asset Management, discusses the factors keeping inflation sticky and what it means for monetary policy.
Transcript
Greg Bonnell: Markets were expecting interest rate cuts to be on the table as we entered the year. But with inflation continuing to be sticky, is that a challenge to the story? Joining us now to discuss, Scott Colbourne, Managing Director and Head of Active Fixed Income at TD Asset Management. Scott, great to have you back on the show.
Scott Colbourne: Good to be here, Greg.
Greg Bonnell: We're not that deep into 2024 yet, so it's really hard to say how everything is going to play out. But we did have expectations entering the year. And as I take a look at the economic data that keeps coming out, particularly south of the border, resilience keeps springing to mind. Is this going to be a challenge in terms of the narrative we're hoping, I think, might come to pass this year?
Scott Colbourne: Yeah. I think we've seen some pushback on the enthusiasm that we finished at the end of 2023, right? So when we look at the last three prints on inflation -- US, Canada, and UK this morning -- it's a little stickier, as you noted. And I think the enthusiasm that we saw at the end of last year when we got the Fed pivot, we've had some good -- we had good inflation, we had a cure -- the quarterly refunding that provided a lift to treasury yields as well.
All that gave us sort of that tailwind that we really had a great finish to '23. And we're just dialing back that enthusiasm. I don't think the narrative of rate cuts is going to go away. It's just more the timing, right?
So inflation is a little stickier, led by shelter and services. And on the other side, sort of goods deflation and energy deflation giving a balance to inflation. So what we've seen is some of the central bankers out there saying, look, we're not pushing back on rate cuts yet. In fact, both the Fed and the ECB have seen acknowledgments of rate cuts this year.
But maybe it's the timing. And so we've gone from an 85% chance of a cut in March to maybe now a 50% chance of a cut. Which, given the probabilities and distributions, that seems like a fair handicap. I don't think they'll cut in March, personally, but I think that is just the dialing back of the enthusiasm. And we're seeing that.
As you noted, bond yields are up over the last few sessions. And it's just taking back that enthusiasm. But I do think we're going to have rate cuts this year, for sure. Global growth ex-US is meh, at best. You've got energy prices pretty lackluster.
If you look at the inflation swaps market, which is something we can actually trade inflation on a month-to-month basis, it says you're going to see core inflation around 2.5% by the second half of this year. I think when you think of the Fed and the reaction function, it's not going to wait until it gets to 2% before it cuts.
Greg Bonnell: It just has the feel, that we will get there.
Scott Colbourne: We're on that path, and we're more confident. And the recent data just dials back the recent cuts.
Greg Bonnell: The last, most recent fresh piece of data, we've found a million ways to say it -- it landed today. It's retail sales. I never know how to take the December number, because I know personally, I might head into the holiday season saying, fiscal discipline, blah, blah, blah.
But it's the holidays. You end up opening the wallet. And when you take a look at how much you spent, you go, whoa. But it was a resilient number. Is it surprising that the US consumer, in particular, has been able to look at higher borrowing costs, look at an uncertain economy, and say, hey, I'm just going to keep on spending?
Scott Colbourne: Yeah. It's been a consistent theme, right, through '23. And so to the extent that it continues at the margin that the US consumer surprises us a bit, I guess we shouldn't be surprised. But I think broadly speaking, the weight of global growth will weigh on inflation.
And I think that we'll probably see OK US growth. And that data is consistent with that. But perhaps reflecting what was priced into the market, that's why you're getting a pushback in yields that maybe we expected a lot softer growth. And it's just a pushback against expectations.
Greg Bonnell: Now, when it comes to fixed income investing, of course, people have an idea about interest rate cuts on the horizon - when they might come, what it could mean for their fixed income portfolios, but also the fact that we're seeing these yields still at fairly high levels. You put all of this together, what does it actually mean for fixed income this year?
Scott Colbourne: I think it's a great year, right? You're talking, depending on where you are, investing in the yield curve or what type of solution you have. 4.5% to 5.5%, or 6% all-in yields - sometimes you take it with duration. Sometimes you take it without. If you take it with duration, I believe that you're going to see maybe another 50 basis points rally over the course at some point this year.
And so that gives you another couple of percent in terms of a total return. So you could have high single-digit returns on fixed income. At worst, you're going to have, I believe, a coupon type of a year. And based on where we were at the lows of the pandemic, income in the 4% to 6% range is reasonably good. So it still makes sense for your portfolios, absolutely.
Greg Bonnell: Will that be enough to get the investors who have been in cash and who have been cautious? All through 2023, we kept hearing about the amount that people were in cash or on the very short end of any fixed income instruments - a little more, perhaps, courage to step in in a more profound way?
Scott Colbourne: Yeah. I think that cash will eventually go to other places when they're nudged. And when are they going to get nudged is when they see central banks, ultimately, cutting. So maybe we've got another third of the year to go through before we get to a significant movement out of cash. But for the time being, whether it's cash, short corporates, or long-duration assets, there's a home for fixed-income investors this year.
Greg Bonnell: If we're taking a look at risks this year, obviously, there's geopolitical risk, there's maybe political risk even in the United States. There's a lot of moving pieces this year. What do we need to think of from a fixed-income perspective? If we say the base case is we expect at some point we're going to get some rate cuts, you're already getting this coupon - what could mess this up?
Scott Colbourne: Good question. I think there are a couple of things I'm looking at. One is commodity prices. What is it really telling us, right? If we continue to see, despite resilient US growth, weakness in commodities -- is it telling us something about demand? Is it telling us something more about further weakening in the global economy?
And so I don't know at this time, but it's something I'm keeping an eye on. And the other thing, I think, from a fixed income point of view and portfolio construction, I look at three things. One, it's liquid, right? So you can shift from fixed income to cash, to alts, to equities. That's always there.
We've got income, and we just talked about that. But it's the correlation between equities and fixed income. And in a high inflation environment which we've been through, that correlation breaks down. And that hedging value breaks down. And there's not a natural demand for fixed income if risky assets go down.
As we go into a lower inflation environment, we expect that correlation to go back up. If it doesn't, that's a risk given how much governments like to finance their debt through the bond market. That is a risk for me as a fixed-income investor - that bid for bonds might not be there. And that's a risk beyond the traditional geopolitics that we're talking about.
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Why Markets Are Starting To Rein In The Potential Timing For Rate Cuts