2023-06-27 18:01:24 ET
Summary
- The article discusses the impact of recent rate hikes on the market and how they have been priced in.
- It compares the ISM (Institute for Supply Management) index with interest rates to analyze inflation-leading indicators.
- The article uses various data sources to support its analysis and conclusions on the relationship between rate hikes, inflation, and economic indicators.
The Federal Reserve paused its interest rate hiking this month, providing an important milestone in the bond market cycle. Although the Fed is forecasting a few additional rate hikes, the end of the rate hiking cycle is now within sight. The peak in rates often coincides with a good time to buy bonds.
Two major factors are required for bonds to perform well in the quarters ahead. The first is that inflation moderates. The second is that economic conditions weaken, prompting a flight to safety, followed by rate cuts. As of now, inflation remains sticky, and the economy appears to be strong. This is incentivizing the Fed to remain steadfast in rate policy. Like all markets, the bond market prices in current news and expectations for the near future.
We believe that economic circumstances have entered into the territory that is supportive for bonds. Once policy, inflation, and economic activity reach a point that bonds are clearly attractive it will be too late , the market will have priced it in.
The data suggest that the potential for bonds is positive. In the case that our interpretation of the data is inaccurate, there is a strong probability that rates will move little, and we can walk away with earning 4%+ yield on our investment. We like the iShares Core U.S. Aggregate Bond ETF ( AGG ) because it is liquid, contains a portfolio of investment-grade bonds heavily allocated to Treasuries, offers a 4.7% yield to maturity, and has a weighted average maturity of 8.67 years. This intermediate-duration bond fund is where we are starting to build a position in our portfolio.
The Last Rate Hikes
Intuitively, one would expect that interest rates have been rising because inflation has been rising. It's more accurate that rates have been rising because the Fed has been raising the Fed Funds Rate and consequently the Reverse Repo Rate . These rates act as a benchmark for other rates. It is uncommon for market rates to diverge wildly from these benchmark rates. For these reasons, when the Fed begins to pause, it catches our attention.
Below is a chart of the 10Y, 2Y, 1Y, and 6M Treasury rates since 2020. Notice that since the Fed began raising rates in early 2022 how all rates have climbed higher but at different rates. The 10Y, notably, has lagged behind the shorter-dated Treasuries, resulting in a yield curve inversion. This is a sign that the bond market expects lower inflation between 1-2 years away and 10 years away. It's also commonly a sign that the bond market expects economic growth to weaken.
Looking back at 2006-07, the Fed raised rates until mid-2006, where all the rates peaked at around 5.3%. During the Fed pause from 2006-2007, rates mostly moved sideways, putting in a type of double top before falling dramatically into the 2008 recession. The past few rate pauses have transpired similarly.
The Fed is forecasting two further rate hikes in 2023 for a total of 50 basis points. The futures market is assigning a 76.9% probability of a rate hike in July. We previously published that we think the Fed is done with its rate hikes now. Because the market is pricing in the likelihood that the Fed will follow through with its forecast, we expect that if the Fed were to walk-back those expectations this would be bullish for bonds in the near term.
Inflation
Last week, The Economist published a magazine cover with the title "The trouble with sticky inflation." We watch for these signs of sentiment as contrarian indicators and believe that this one deserves merit.
US CPI and PCE, a preferred measure of the Fed, are two of the most lagging inflation measures due to the methodology of the indexes. In particular, the cost of shelter inflation is especially lagging. We do not prefer CPI as a reliable measure of inflation and prefer to examine multiple datasets for a clearer understanding. The US Producer Price Index is one such dataset. We can see that PPI peaked at 12% in early 2022, about three months prior to the peak in CPI around 9%. The ISM Services Prices Paid Index has mirrored PPI closely. While the CPI is at 4.05% today, the PPI is at 1.09% and ISM SPP Index confirms the disinflationary trend. We would expect, based on this data, that the CPI has at least 3-6 months of disinflation to come with an end-of-year target of around 3%.
Data is beginning to identify a slowing in the increase in rent rates in the U.S. Redfin has found that nationwide asking rents are down 0.6% YoY. In addition, the median sales price for new houses in the U.S. is down about 15% from the high. Although some of this is due to homebuilders focusing on smaller and more affordable housing, home prices in May were down at least 3.4% YoY. Rents tend to follow home prices but with a lag. The CPI rent of primary residence continues to power higher despite the turn in housing and rents in real-time. Eventually, this data will exhibit the same weakness and contribute to lower CPI.
The incredible rise in inflation experienced over the past three years is primarily due to the sudden expansion of the money supply. U.S. M2 money supply rose over 25% YoY in 2020, the highest in over 50 years. Since the Fed began its monetary tightening, M2 is now shrinking by the fastest pace in over 50 years. While the relationship is imperfect, changes in M2 influence inflation. The trend in M2 also supports lower CPI in the coming months.
Economic Conditions
Policymakers set interest rates in relation to economic growth. The Fed will be hesitant to cut rates until economic conditions are bleak, and this is especially true while inflation remains elevated. This unprecedented rise in inflation has caused the ISM Manufacturing PMI, a measure of economic growth, and interest rates to diverge strongly. The ISM PMI suggests that an appropriate level of interest rates would be around 2% for the 10-Year Treasury.
Real GDP in the U.S. remains positive but real GDI has turned negative for the past two quarters. These measures are very similar and often move in unison. The potential for recession in the U.S. is significant if GDP were to follow GDI below zero.
Some recession probability indexes are registering warnings that correspond with the economic data above. When the U.S. enters recession, interest rates most often fall.
Summary
The Federal Reserve is in the process of pausing. We believe the Fed will likely back down from hiking further. The market expects the Fed to follow through with higher rate hikes. Data suggests to us that inflation will continue to decline and economic growth will slow. This trend has the potential to accelerate under the right circumstances such as if unemployment begins to rise.
The iShares Core U.S. Aggregate Bond ETF contains an attractive portfolio of bonds offering a 4.7% yield to maturity with an effective duration of 8.67 years. This offers a higher yield than the 10Y treasury at 3.7% and the 7Y Treasury at 3.8%. This is despite 41.95% of the portfolio constituting U.S. Treasuries. Based on history, we would expect that while the Fed pauses rates, the yield to maturity will remain around 4.7%, offering us a solid positive real yield. If inflation continues to moderate and the Fed eventually cuts rates to support the economy (which may occur after six months, 12 months, or longer) we expect that the yield to maturity for AGG could trade down to 3.8% which would correspond with about $104 per share. Depending on the time frame, this scenario can offer double-digit or high-single-digit returns over the next 12-24 months.
For further details see:
AGG: The Turn For Bonds Is Near