Inflection Point for the Fed: Fixed Income Scenarios
The path for monetary policy is to begin lowering rates in the months to come, as reflected in the forward rate projections. Inflation continues to trend lower, and the labor market is cooling, perhaps more quickly than previously thought. The Federal Reserve (Fed) has signaled that rate cuts are on the horizon, almost certainly beginning in September. At the July FOMC meeting, the tone shifted with the Fed highlighting that risks to inflation AND labor markets are more balanced. This suggests they will be quicker on the trigger if labor markets deteriorate faster than they are comfortable with. This sentiment was confirmed in Jerome Powell’s speech at the Jackson Hole symposium in late August. The market reacted strongly to the weak July employment report by rallying and steepening. Although the curve has retraced some of that, the reaction is indicative of the market’s bull steepening bias.
Recession probabilities remain low, but the market is pricing in aggressive policy easing that starts in September and the "hard landing" scenario has re-entered the debate. The largest unknowns are 1) how fast is the economy really slowing down, particularly the labor market and 2) how aggressive will Fed need to be with policy easing. At present, the market is pricing in 8-9 rate cuts by the end of 2025.
The big question is, what does that mean for interest rates in the near future? The chart below lays out different interest rate scenarios and reflects the expected returns for each.
As you are likely aware, the Galliard investment process is not one to make interest rate calls. Some of these scenarios are more likely than others, but that said, we work to build flexibility into the portfolios to be able to adjust to changing economic conditions as warranted.
The scenario analysis is for illustrative purposes only and is not meant to be a recommendation or forecast. Note, the returns shown to do not utilize the returns of any Galliard strategies. The six-month forward curve is the market implied shape of the curve 6 months in the future based on current market rates. These are the returns that would be realized if the forward curve were to materialize over the horizon. To calculate the scenario returns, the analysis uses the income return from the coupon, rolldown yield, change in rates and a spread of 70 bps. The portfolio is rebalanced monthly. For duration, the analysis uses partial durations of the Bloomberg Government/Credit 1-5 year index.
Date of data: August 28, 2024; Source: Bloomberg Indices.
Note: “Steepener” and “flattener” refer to the relationship between 2-, 5-, 10- and 30-year bonds.