2023-12-15 09:39:47 ET
Summary
- The Fed intends to leave rates unchanged and focus on letting assets like agency mortgages fall off their books. This is good news for bond investors worried about rate risk.
- Some credit risk still remains, so I have my eyes on corporate bonds and 7-10yr Treasuries.
- As the yield curve reverts over the next three years, we can expect substantial price recovery from these two assets.
- There is more risk and more reward in long-term treasuries, but the rate risk is still too much for me on the 20yr UST.
Introduction
The Fed's Jerome Powell spoke on Wednesday, releasing the December FOMC statement and holding a press conference. A transcript of the press conference can be found here .
In that statement and press conference, the Fed gave us very clear indicators in their plans. They intend to leave rates unchanged, staying in the current range, and have shifted only to letting assets like agency mortgages fall off their books as they mature.
I am adjusting my holdings according to this shift from the Fed, and positioning myself further along the yield curve now that I'm less fearful of further rate increases.
Dove Speak at the Meeting
What clued me into us being at peak rates was this quote from Powell during the press conference Wednesday,
Our actions have moved our policy rate well into restrictive territory, meaning that tight policy is putting downward pressure on economic activity and inflation, and the full effects of our tightening likely have not yet been felt.
The Fed doesn't believe the 5.25% Fund Funds Rate ("EFF") has fully affected the economy yet, and until they have a clearer picture, there is no way that they will raise rates. They are very worried about doing too much intentional damage.
Totality of Data
He followed that up with,
Given how far we have come, along with the uncertainties and risks we face, the Committee is proceeding carefully. We will make decisions about the extent of additional policy firming and how long policy will remain restrictive based on the totality of the incoming data, the evolving outlook, and the balance of risks...
"Totality of...data" is really the most interesting part to me, since the Fed has been primarily quoting GDP and unemployment numbers. It tells us that the Fed may allow for rate cuts even if these two major figures don't line up.
They still are using that phrase to mean "Core CPI," just as writers and the Fed were doing in the Team Transitory days .
GDP Growth Slowing, Where's the Recession?
We can see that GDP growth has slowed this year, but there is still no recession, despite the numerous predictions of terrible crashes and recessions through 2023. We may actually get that " soft landing " after all.
Analysts from all over were clamoring in 2022 to announce their prediction of a recession. They still are at the end of 2023 .
Unemployment has also slowed its decline and has been steady just under 4% for most of this year and last. The Fed has been getting exactly what it wants.
However, should these figures not continue going how the Fed wants, Powell reminds us that he is still willing to use his limited tool set to tame inflation.
We are attentive to recent data showing the resilience of economic growth and demand for labor. Evidence of growth persistently above potential, or that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy.
The three major indices the Fed has been using are all coming up Millhouse for Powell et al., and despite inflation still being above 2%, there are at least a few Federal Reserve Chairmen in the past who would've killed for 3% persistent inflation.
Paging Mr. Volcker!
The Good News
In the Q&A after the press conferences, Powell did give us the "good news,"
...the good news is, you know, we're making progress and monetary policy is restrictive. And we feel like we're on a path to make more progress, and it's essential that we do.
Progress means that the Fed will consider rate cuts, and they have proposed a potential 3-4 of them next year . They also indicated that several more might come in 2025 and 2026, with us being down to 2-2.5% EFF by the end of 2026.
Peak Rates
Several times, Powell outright said or hinted at this rate being the peak.
They are still not confirming anything, but Powell was very clear about not wanting to raise rates anymore.
While we believe that our policy rate is likely at or near its peak for this tightening cycle, the economy has surprised forecasters in many ways since the pandemic, and ongoing progress toward our 2 percent inflation objective is not assured.
In response to a question from a reporter at the Washington Post, Powell remarked,
I think you can say that there's little basis for thinking that the economy is a recession now.
And again, to a response from a reporter at the AP,
We believe that we are likely at or near the peak rate for this cycle. Participants didn't write down additional hikes that we believe are likely...
He is screaming to us loud and clear: we predicted incorrectly and now we're done hiking unless something disastrous happens.
So what do we do with all of this info?
The Bonds I'm Watching, LQD & IEF
Naturally, the immediate move at a time of "peak rates," is to buy into bonds that benefit the most from these elevated rates.
Prior to this article, I've recommended a lot of floating rate or adjustable rate instruments. I've also recommended staying on the shorter end of the yield curve .
Now, with this news and confidence from the Fed, I'm feeling more comfortable with fixed-rate bonds.
iShares iBoxx Investment Grade Corporate Bond ETF ( LQD )
The US corporate bond index was slaughtered by the 2022-23 rate hikes and has since started to recover. YTD, the index is up 8%.
While there is still a lot of risk in junk bonds, I believe the worst is now over for investment grade corporates. This is because I was never very concerned with credit risk, as business delinquency rates have shown that those worries are not materializing into proper headwinds.
Figure 7 (Federal Reserve Bank of St. Louis)
That only leaves rate risk on the table, and with the Fed's new shift into dovish territory, that is also not seeming to materialize as much as a concern as it was once thought to be.
At a forward yield of 5%, investors stand to gain a fair yield with some price appreciation. We are still fairly far off the highs from when we had more "normal" rates that the Fed wants to return to.
Note that this yield is currently lower than the shorter end of the curve, but stands to stay this high for far longer than T-Bills once rates start to decline.
This chart should give investors confidence in a purchase here, as we haven't seen prices this low for the last ten years.
iShares 7-10yr Treasury ETF ( IEF )
Recently, I wrote about how being on the shorter end of the yield curve makes the most sense for investors' cash savings right now, but I also do not want to take a position further along the curve.
The curve still looks steep, but that should provide us with some level of price appreciation as the curve reverts back over the next few years. Rate cuts are expected to continue at a gentle, consistent pace until we hit our terminal 2% rate in 2026.
Figure 10 (Federal Reserve Bank of St. Louis)
The intermediate term looks very promising currently and has a setup like LQD but without as much credit risk. One should also consider, if you are willing to take on more risk, the 20yr bonds. They are very beaten down from their highs and have considerably more upside, but also pose more downside risk if there is a black swan or something else unexpected that raises rates again.
The 10yr Treasury stands out in particular among the lineup of treasury ETFs because of its power as a high-yielding asset for when treasury yields revert back to a more "standard" curve. As the rates slowly fall, as the Fed intends, the curve should start to revert, and it will do so around the 7-10yr mark, which sits on a "hinge" so to speak.
This provides us with the best risk/reward opportunity in treasuries currently.
The 20yr carries a lot more convexity, meaning that it will extend its duration by about 3-4yr for every 100bp of falling rates. This may prove problematic to investors who do not want too much rate risk. The further rates fall, the more rate risk is added back to treasuries and at a much higher rate for the 20yr than the 7-10yr, which sits at a convexity of 0.6yr for every 100bp rate movement.
That being said, we're still 100bp away from the highest yield on IEF, and if rates rise again for whatever reason, investors could get burned holding these over shorter-term T-Bills. Below is the 10yr yield chart for this past year.
This is why I advise caution around holding TLT currently. The 20yr does not have sufficient reward for the amount of risk one needs to take to hold it.
Conclusion
The Fed has turned dove on us and laid out a plan to cut rates over the next few years. While some credit risk still remains for junk bonds and some rate risk still remains for long-dated treasuries, there is a nice sweet spot.
That sweet spot is currently investment grade corporate bonds and the 10yr treasury, both of which provide solid yields for fixed rate instruments and present with low convexity, meaning duration should not change too much as rates fall.
Since we are no longer expecting rates to rise, floating rate debt has become less attractive looking for the future. I still recommend floating rate debt and have positions in the CLO ETFs [[JAAA]] and [[JBBB]], but am now entering into fixed-rate positions outside of mortgages again.
Thanks for reading. Please leave a comment below if there are other fixed-rate bonds you're keeping your eyes on.
For further details see:
The Fed Hints At Peak Rates, Here's How I'm Playing It