How to Position Bond Portfolios as the Fed Ponders a Pivot

How to Position Bond Portfolios as the Fed Ponders a Pivot

Rob Costello

Hello, everyone. My name is Rob Costello and I’m a client portfolio manager here at Thornburg Investment Management, coming to you from our headquarters in Santa Fe, New Mexico. I want to welcome all of those attending this webcast, “How to position bond portfolios as the Fed ponders a pivot”. I’m delighted to be joined here by my colleague Jeff Klingelhofer, who is a co-head of investments at Thornburg and a portfolio manager on our global fixed income strategies.

Jeff, it’s nice to have you on this webcast today.

Jeff Klingelhofer

Great to be here. Look forward to the conversation.

Rob Costello

At the Fed’s March meeting, they left rates unchanged, which everyone expected, and the FOMC still expects three rate cuts by the end of the year 2024. But what was most interesting is that the forecast for the number of cuts remain the same, despite the committee revising upward their forecasts for growth and inflation.

So, share with us your thoughts, Jeff, on how you interpret the Fed’s reaction function right now.

Jeff Klingelhofer

Yeah, and this is, look, I guess it to me is just very much an evolving conversation, something we’ve been talking about for the last year plus. I think it’s important to remind ourselves where we’ve come from and what the Fed is actually trying to accomplish at the highest of high levels and as we have talked about in the past, we have to first start with the Fed is it does not have two mandates. Oftentimes we think about it as a dual mandate central bank: price stability, maximum employment. But it’s their Congressional charter, the legal mandate for U.S. law, is to pursue maximum employment, price stability and moderate long-term interest rates. And I think key to your question is focusing in on what that third mandate means. We’ve talked a lot about that–it doesn’t necessarily mean moderate long-term interest rates because those are variable, and they depend on the state of the economy.

We’ve asked a couple of former Fed officials and they’ve said exactly that. But what they’ve also said is, there is flexibility on how they pursue and how they order those first two mandates, price stability, and maximum employment. And that’s actually changed quite a bit here just very recently. Looking backward, it was one of trying to focus on financial stability.

Right? This is QE one, QE two, the Fed coming to our rescue. Looking forward, I’ve argued it’s one of compressing the wage gap and that therein lies the reaction function in some of what we saw this past Wednesday at the FOMC. You’re right. They revised or they talked about forelook inflation as being higher than they had at the prior meeting.

But what they didn’t do is signal that they cared a bit about it. They signaled that they were still going to cut three times. And so, I think first, that’s a bit preemptive from the Fed. I don’t think they’re going to cut three times this year, but we’ll see. But in terms of directly answering your question, the reaction function is one of so long as the economy is working and so long as it’s one where the source of inflation that we’re getting is, “good inflation”, it’s wage inflation, it’s low wage income earners exerting upward force on the labor market, I think the Fed is very confident and they want that from inflation. They’re willing to tolerate that form of inflation. If it switches to “bad inflation”, just broad goods inflation, wage price spiral inflation, then I think the Fed might change their tune. And I think the part and parcel to your question is that’s what I worry about most at this point, is we’re taking too much confidence there as we watch the very easy inflation prints from a year ago, that looking forward, the market is confident that we’re going to continue.

Inflation will just kind of march systematically towards that 2% or even get stuck at 3%. But actually, what I worry about is we’re seeing a number of indicators hook back up, and that leaves us a little bit fearful that the Fed may have to take even one of those or all of those rate cuts off the table here as we look forward. The reaction function is out with the old. They’re not focused on financial stability. They are focused on a balance between maximum employment and price stability. But 3% inflation, I think, is the new 2% inflation. We’re just going to have to get used to that within markets.

Rob Costello

So based on these views, Jeff, what is your expectation for the number of cuts by year end?

Jeff Klingelhofer

I’ll do it in classic portfolio manager, asset manager format and I’ll give you two answers. And I think it shouldn’t surprise you that it really hinges on whether we have a recession. Assuming we don’t have a recession, which is what markets are pricing for here, which is very, very challenging because markets are exceptionally confident that we’re not going to see a recession. When you look at market-based measures, gosh, they’re very, very tight in terms of spreads and P/Es and all sorts of other metrics. But I wouldn’t count us out of the camp at all. I would argue that we continue to see a number of challenges in the face of these market metrics that suggests a recession is very much a potential and on the table. And so, if I have to put my number to a no recession scenario, I think we get one cut. But if we do get a recession, which is absolutely a possibility, I think the Fed will be much less inclined to cut dramatically, though they will be forced to cut.

In that scenario, I would say 4 to 5 is a reasonable base case. And look, I think when you blend those two scenarios, that’s kind of what you get from what the Fed is signaling are market-based measures. But it is very bifurcated on the state of the economy.

Rob Costello

Jeff, you recently did an interview on Bloomberg TV and caught the anchors by surprise when you said a rate hike, while premature to discuss, shouldn’t be entirely off the table. Is the market underestimating this possibility?

Jeff Klingelhofer

I think they are underestimating the possibility, which is generally what markets do, right? Markets oftentimes get into the habit of pricing a sole scenario again, and today they’re pricing in a soft landing. They’re pricing sorry, they’re pricing in no landing. They’re pricing in zero probability of recession. And I think a challenge whenever markets do this is none of us know what tomorrow holds.

We can look at the broad economy, but we can’t look at the shocks to the potential economy because we don’t know what those shocks are. But before we go down a rabbit hole, you’re asking a very direct question. I think the way that the Fed would be forced to not cut, but actually potentially hike, is if we see a move back up in inflation.

I already said, I think 100%, I worry about that as being the classic potential problem. Right? It is what we experienced in the seventies and eighties, but really what it comes from is exactly the situation that the Fed has engineered. So, props to the Fed who can pat themselves on the back. We’ve gotten inflation from the problematically high 9-ish% inflation to a pretty tolerable three %.

That is inflation that nobody really thinks about from a capital allocation perspective, right? It’s just the world doing what the world does. Prices go up a little bit and everything is fine. Now, that’s not to dismiss the overall price levels notably higher, but that’s a subject for perhaps another day. But I think that we’ve taken too much comfort that we’ve been going down in inflation.

We’re forgetting that what we’ve engineered in the wake is that wage inflation, services inflation, in particular. And that has a way of feeding back into prices. So I think it’s safe to say that one of a couple of things are going to have to happen. Either we need the labor market to weaken and that probably causes a recession…

The market’s not pricing that. I think the other thing is there’s a potential we get a soft landing, but there’s a very strong labor market and high wages keep inflation going. And that’s problematic for the Fed. They might actually have to hike. I think the last thing that we might want to discount or potentially talk about is that if we avoid a recession, the companies just have to eat into margins because wages continue to move up.

But the Fed does bring the link at the final prices. And so, again, two of those are relatively… actually, probably all three of those are challenging for full markets as we look forward.

Rob Costello

Jeff, let’s pivot to the US economic trajectory. The Fed’s confidence to even hold rates at the level that they are currently is predicated on the long-anticipated recession not coming to fruition.

The consumer remains broadly employed with the unemployment rate still below 4%. But it’s interesting to note that despite the robust labor market, credit card delinquencies have been steadily rising. Are you as sanguine as the Fed about the growth trajectory right now?

Jeff Klingelhofer

I don’t think my answer will surprise you, given some of the remarks that I’ve already made.

But I will say one thing. I’m not sure the Fed itself is as sanguine about the economic recovery, but I will say the markets absolutely are. And no, I’m not as sanguine just broadly as either of them, because as we see, we’ve said this in the past, in the world of low interest rate alchemy is over. Low rates were a boon for a lot of people– on corporate balance sheets, on government balance sheets, and on consumer balance sheets. It supported a lot of things that really are much more difficult to support in the future. And now it’s been a tremendous surprise that in the face of high and rising rates, rising inflation and rising rates, the consumer has held in as well as they have. But that doesn’t mean that they’re going to continue, because what is happening is we are seeing data weaken almost every single morning data does continue to weaken. Right. We just got housing starts this morning, housing data, and it’s weaker than the market was expecting. Yet the employment rate for housing construction is at all-time highs. This is a disconnect that can’t continue in perpetuity and it’s a potential source of weakness, right? Either housing starts need to increase dramatically or what has to happen is unemployment within the housing sector needs to come down.

Another one we’ve talked about is gross domestic product versus gross domestic income, or one measure of total “How’s the economy doing?”, gross domestic product (GDP). It says everything is fine. We’re growing roughly 3% year over year. But another measure that is supposed to say the exact same thing because it measures the exact same thing as another pure measure of gross domestic product, the income-based approach, gross domestic income (GDI), says we’re not growing at all. We’re actually contracting. And so, it’s data like this. And I can rattle on data series after data series, household employment versus the establishment survey, all sorts of these things point to just different outcomes of the economy. And the market is betting all chips on one. But I’d say that we’re less sanguine as we digest the data and says the variability, the potential can really head in multiple directions, and we should be pricing for some of that unknown.

Rob Costello

Jeff, let’s go back to the inflation front for a second. And the Fed expects core PCE, which is their preferred measure of inflation, to end the year at 2.6%. And that’s not that much different from where this particular measure of inflation is currently, at 2.8%. Do you believe that inflation is going to be a lot stickier then than the market is expecting at this point. And why? What are you seeing in the data?

Jeff Klingelhofer

Yeah, I do. I think it’s important to remind ourselves that getting from point A to point B is not necessarily a pure straight line. I wouldn’t be surprised to see inflation continue to tick lower here in the short term, although if anything, again, it has really leveled out and it’s starting potentially even to stick higher.

But over the medium-term rate and not a tremendously long time because I’m not talking five, seven, ten years. I’m talking about, not necessarily data point to data point, but on a three- or six-month rolling average, I think the composition of inflation that we’ve seen has shifted tremendously where goods inflation is now running at essentially 0% and services inflation is running at four or slightly higher. Wage inflation is running at five.

That’s the source of inflation that is much harder to squash out. Right? Because if the labor market remains very strong, consumers have high income. They want to go out and they want to spend and therefore they support the ability of companies to continue to price at higher price levels proactively and looking forward, that raises the level of inflation.

And so, I think we’ve squashed out all of the easy to squash out sources of inflation, a lot of the supply side constraints that we had going through COVID. And I think what we’ve ended up with is a much stickier form of inflation, and it potentially could even reverse the inflation picture outright. Now, the reason why I wanted to start off with a little bit of that, is, look, we have to remind ourselves that’s not a straight line is because we continue to have a challenge with owners’ equivalent rent.

We’re in the official CPI numbers. It hasn’t come down. And what a lot of economists have talked about is we know the direction it’s heading. We know that rents have come down. We know it’s going to come down over time. And because of that, we know that broad inflation is going to come down over time. And I would say that’s right.

But again, with one caveat, why has rent come down? Because houses aren’t depreciating at significant levels for a while and that was looking backward. But today, as we look forward, housing prices are continuing to move up at an increasing level. I think what we should expect is rent will come down, but then it will also hook back up.

We just need to remind ourselves the most sticky and largest form of inflation is essentially stuck at three. And I think that stops that downward trajectory the Fed is looking for.

Rob Costello

Jeff, since the Fed has not been in a rush to lower rates, overall yields have remained compelling. In the fixed income markets, spreads have grinded tighter.

We have seen that, in fact, the Bloomberg high yield index spread recently dropped below 300 basis points, which is fairly low by historical standards. Check out this chart that shows the number of days over the past 20 years where the high yield market has traded below 300 basis points of spread. Is the market too complacent right now?

Jeff Klingelhofer

No, no, no, I’m just joking because based on everything I’ve said, right, it’s the market is pricing for a singular outcome, and I would say as a base case, it’s not a terribly bad outcome. I personally still put myself in the camp where I think we’ll see a mild recession later this year. I do think the bite of higher rates is doing exactly what it is supposed to do. I think markets are taking way too much comfort. Coming out of 2022 to 2023, we had the exact opposite, with markets pricing for a recession.

The base case was we we’re going to get a recession in 2023 and we didn’t. We were surprised. The market was surprised. But I think the wrong reaction function from the market is saying, well, gosh, we didn’t get you know, we didn’t get a recession in 2023 and therefore we’re never going to get one. And I think that’s wrong because I think the mistake the markets made was on the back of the fastest and highest interest rate hiking cycle that we have seen really in any investor’s lifetime, it is reasonable to expect that this would compress the business cycle. You would jump to that potential recession in a faster way than history had normally done. And that, again, that was wrong. But what we’re just coming into is now the historically normal time period of when higher interest rates actually do lead to a rise in unemployment, actually do lead to a rise in GDP, I’m sorry, a fall in GDP, and I think the market is way too quick to say, well, the consumer is in a relatively strong spot. And I think what they’re failing to recognize is overall, yes, they are in a relatively strong spot, but a much less strong spot than they were. And once you get on a downward trajectory, the economy tends to work in business cycles, right.

That’s what we always learned about. And it’s because high confidence is a self-fulfilling prophecy. When I feel good, I go out and spend. When I spend, the store hires more store clerks, and then the store clerks are more employed. They go out and spend. The line just kind of continues. It’s a virtuous cycle, but today we have the exact opposite from that virtuous cycle, right?

If I don’t feel perhaps as confident, I don’t go out and spend, which means maybe Home Depot actually hires a couple of less store clerks and then they don’t go out and spend. And you are seeing unemployment rise. You are seeing consumer disposable income coming down. You are seeing small businesses say, “We actually don’t need to hire nearly as much as we thought we did.”

And high yield today is pricing essentially a 0% probability of recession per your own chart. It’s certainly not normal to stay at these levels for any period of time. It’s not historically normal to be here for any period of time. And I think the market’s just outright dismissing that. Yes, there is a possibility of a right tail, a very good outcome. There’s also a possibility of a left tail. And we have to think about when we’re paid to take risks, we are willing to take that risk in the portfolios, but vice versa. when we’re not paid to take that risk, we want to focus on defense for clients. We want to focus on building durable fixed income portfolios and really continuing the Thornburg track record of protecting on the downside.

Rob Costello

So, Jeff, let’s turn briefly to the municipal bond market. Can you share with us our current views on munis, and where opportunities are and where risks may be lurking?

Jeff Klingelhofer

I think at a very high level, all of the comments that I’ve shared just on the world obviously should apply to municipals as well, right? They’re one of the government balance sheets.

We oftentimes think about Treasuries, but there’s all of the state and local governments as well. And I would say just like the world of fixed income within the world of munis, the world is bifurcating. You have stronger issuers. You have less strong issuers, but by and large, even the weaker issuers are continuing to travel on.

And it’s those from a cyclical perspective that if there was to be a slowdown that we would worry about most. I think the biggest difference between the world of municipals and taxable fixed income is curve differentials, right? So the US yield curve is largely pinned on the front end of the yield curve and it’s been the long and that’s been more variable.

So we’ve been above and below 4% and sometimes in pretty dramatic moves. And so that is the opportunity. It is to take advantage of some of those shifts. On the municipal side, it’s almost the exact opposite, where the belly in the longer end of the curve has been somewhat fixed. And it’s the front-end variability as folks come off of cash that seem to be very supply demand driven.

I would say where we had been finding more opportunity in municipal market is with clients saying, you know, the front end or sorry, the back end, but the longer end of the Treasury curve, the longer end of the corporate curve looks less attractive and there’s a pretty good opportunity to move into municipals on a tax adjusted basis. But a lot of that has been priced out.

We’ve seen spreads tighten in really dramatically there as well. And so by and large, I would say it’s a very similar setup where we want to take risk where we are paid to take it with the municipal portfolios. Not saying there’s no opportunity to do that. There very much is. But on a holistic high level, we really want to play defense as well as in the portfolios.

We want to focus on many of those more asymmetrically oriented opportunities that really shouldn’t move around from a fundamentals perspective into any signs of weakness.

Rob Costello

I appreciate those comments and I want to thank you for your time and your insights today. And we’re going to bring the webcast will close. And I want to thank everyone for attending. Please rate this webcast. If you see the pop-up window appear, we’d love to hear what you think, and we will be making you aware of future webcasts.

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