The Fed and Avoiding FOMO in Fixed
After a nine month pause, the Federal Reserve (Fed) cut the Fed Funds rate by 0.25% on September 17th. Given the Fed’s bias to regular communication with the market, this move was expected by the stock and bond markets. Future Fed behavior remains uncertain as Chairman Powell said “there is no riskless path” with both the employment and inflation outlooks unclear. Despite some economic uncertainty, the stock market continues to make new all-time highs and, correspondingly, credit spreads / risk premiums remain exceptionally tight. We continue to find select opportunities in fixed income, but we strongly encourage investors to avoid getting FOMO (Fear of Missing Out) in Fixed Income.
While the Fed’s behavior and forecasted policy can have an impact, the market ultimately dictates the prevailing interest rates of Treasuries. (Reminder: the Fed only directly controls the Fed Funds rate which is the overnight rate between banks on excess deposits.) This dynamic explains how the Fed can cut rates yet Treasury bond yields can hold steady or rise slightly. Looking forward, we forecast the Fed to remain extremely data dependent. The Fed’s most recent summary of economic projections assumes two more 0.25% cuts in 2025, which is in-line with current market expectations and equates to a Funds rate of 3.5%-3.75% by year-end. Currently, there is tension between the Fed’s dual mandate, because the employment picture has shown some weakness recently, yet inflation is closer to 3%, well above the Fed’s long-term target of 2%. Furthermore, potential inflation uncertainty remains in regards to tariffs. It is too early to know what percent of the tariffs will flow through to consumers. The prevailing thought is that tariff inflation should be one-time in nature if the current tariff levels persist. However, many tariff disputes remain unresolved and tariffs have met legal challenges so there are many unknowns. We will continue to monitor the economic data and resulting Fed actions to position ACM portfolios appropriately. As we have said numerous times, the performance of a fixed income portfolio should not be solely driven by a bet on interest rates. We believe active management and security selection are more important and repeatable over time.
While the days of 6+% yielding corporate bonds of two years ago are gone, intermediate investment grade bonds still yield nearly 4.5% today. This compares to the average high yield bond, which currently yields just more than 6.5%, which we deem insufficient for the additional risk. We remain near the lowest high yield allocation we have been in more than seven years. The reason for this positioning is that high yield credit spreads remain near 25-year lows and the argument to be overly exposed to high yield is weak at best. (Reminder: the credit spread is the additional yield or risk premium earned on a bond in excess of a Treasury with the same maturity). As individual bond buyers, we can always find compelling opportunities in high yield, but the pickings are slim currently.
On the other hand, we think the total return (price change + coupon) prospects for investment grade intermediate corporate bonds are still favorable whether growth is strong, slow, or even slightly negative in a recession. Investment grade spreads typically don’t widen by more than 1% during sell-offs, while high yield spreads could easily widen by 2-3+%. In a recessionary environment, the decline in rates would provide a meaningful buffer to any price risk for intermediate investment grade bonds. Additionally, high yield companies are more likely to default in a recessionary environment given they generally have weaker balance sheets, so we remain conservatively positioned.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.