Expect A Busy Second Half of 2024 in Fixed Income
Co-Author: Kevin E. Strauss, CFA, Partner / Portfolio Manager
It is now widely expected that the Fed will likely begin reducing the Fed Funds rate during the remainder of 2024, so some investors who have been hiding in money markets are reassessing their options. Additionally, the November Presidential election could impact the outlook for fiscal policy. All of these factors could significantly influence the fixed income market in the next six months.
The Fed took drastic actions in March 2020 after Covid struck to implement extraordinary accommodative monetary policy. However, two years later it was time to sharply reverse course. In March 2022, the Fed initiated an aggressive, but necessary hiking cycle. After raising the Fed Funds rates a total of 5.25 percentage points to the current range of 5.25-5.50%, the Fed has been on pause since July 2023. Now, with some lag, Fed actions are having their intended effects of slowing economic growth and cooling the labor market. Remember the Fed’s dual mandate is to promote maximum employment and stable prices (approximately 2% inflation). As Fed Chair Powell said recently, high inflation is not the only risk that he is concerned with, as unemployment is currently at 4.1% versus a January 2023 low of 3.4%. To be clear, 4.1% is still a relatively low number by historical standards, but the Fed does not want to see this number rise significantly just to ensure it achieves a 2% inflation rate.
This year has proven once again that sometimes the market just believes what it wants to be true. To start the year, the market was pricing in nearly seven 0.25% cuts by January 2025 versus the current expectations of approximately three 0.25% cuts. ACM believed seven 0.25% cuts was too aggressive to start the year. So many rate cuts required a recession, which we were convinced was not in the offing. We currently think one or two cuts are likely this year. Three or more cuts would require more economic weakness than we think likely. Given the presumed downward path of the Fed Funds rate in the near future, we are overweighting our exposure to bonds maturing in 3-7 years. These securities can benefit from rate reductions, while still ensuring duration does not get too low or too high.
While money markets have proven to be a reasonably good place to hide for the past two years, many investors are realizing that money market funds are perhaps not the best medium- and long-term solution. Per Fed Data as of 1Q’24, money markets increased by nearly $750 billion from 1Q’23 and are up more than $1.7 trillion to over $6.4trn compared to $4.7trn as of 1Q’20. More recent weekly data as of 7/17/24, per the Investment Company Institute, shows that money market funds may have peaked or flatlined. Based on the Fed’s June 12th Summary of Economic Projections, the Fed Funds rate is projected at to reach 4.1% by the end of 2025, 3.1% by the end of 2026, and 2.8% over the longer run. This highlights that investors may be unrealistic if they expect money market rates to remain around 5% in perpetuity. This outlook highlights why investors should not think of money market funds as an alternative to a fixed income portfolio. Many money market investors may not realize that the Barclays Intermediate Corporate Bond Index (composed of 1–10-year Investment Grade Corporate Bonds) has returned more than 9.5% in the past 19 months versus money market funds that would have returned approximately 7.9% over the same period (assuming 5% annualized). Investing in money market or very short dated securities exposes investors to significant reinvestment risk if/when short-term (0-3 years) interest rates decline. These elevated money market flows will likely get invested into a combination of public fixed income, private credit, public and private equity, and some eventually will go back into bank accounts based upon people’s risk appetite. Investors who have large money market allocations may want to now consider the best options for themselves.
The upcoming November Presidential election has the potential to significantly impact long-term interest rates. As a reminder, the Fed controls the Fed Funds rate, which is an overnight rate. The yields on intermediate and long-dated Treasury bonds are only marginally influenced by near-term Fed policy. On the other hand, fiscal policy can heavily influence intermediate and especially longer-term interest rates due to the size of annual government surpluses or deficits as well the level of total government debt. The current betting odds of an all-Republican sweep of the Senate, House, and Presidency are 44% versus 17% for an all-Democrat sweep (as of 3pm 7/21/24). We recognize that these probabilities may or may not change significantly going into the election with Biden stepping out of the Presidential race. In the near term, we think the fixed income market would initially view a sweep by either party as inflationary until actual legislation is passed. We think a non-sweep would likely be viewed as more of a non-event in regard to long-end Treasury rates. While we are always somewhat limited in our exposure to long-term rates, we currently think it is prudent to strictly limit exposure to very long-dated rates (20 and 30 year) until we gain further clarity following the election.
Regardless of the exact Fed path or the outcome of the Presidential election, the next six months will present compelling opportunities in Fixed Income. As we have said repeatedly, ACM believes active management is essential in Fixed Income. We remain nimble and opportunistic to help clients benefit from active management in an ever-evolving Fixed Income landscape.
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