restrain Your Enthusiasm. Larry David’s enduring HBO series title may serve as wise investment guidance, considering the substantial surge in bond and stock values following the report of a mere 0.1% increase in consumer prices for October. This outcome was in line with economists’ predictions. The core consumer price index remained unchanged for the month (after dropping from a 0.04% increase), while the “core” measure excluding food and energy expenses was up 0.2%.
Thank you for reading this post, don't forget to subscribe!In October, inflation registered zero, following a further decline in housing expenditures. Over the past year, overall consumer prices increased by 3.2%, while core prices rose by 4.0% and core prices excluding housing saw only a 1.4% rise. Essentially, for individuals not consuming food, using a vehicle, or covering expenses for electricity, heating, hot water, or housing, inflation was insignificant.
These assessments incited a market frenzy, indicating more about investor psychology than the economic well-being. Ordinary individuals are witnessing escalated prices, with round numbers climbing by 18% since December 2020, and dismissing the lower inflation rate as elitist is evidence of minimal inflation. On the other hand, Wall Street interprets the decline in inflation as a signal of the Federal Reserve finally ceasing interest rate hikes and anticipating an early rate reduction next year.
The federal-funds futures market anticipates four 25-basis-point (one-quarter percentage point) cuts by the conclusion of 2024, considering the latest CPI data, as per the CME Fedwatch site. Forecasts from the current target range of 5.25%-5.50% echo an initial reduction around May Day next year, followed by another in late July, and further tweaks in mid-September and mid-December.
The most recent Bank of America global fund manager survey, released directly preceding Tuesday’s CPI report, demonstrated that professional investors were already anticipating this. Approximately 61% were expecting diminished bond yields, marking the highest proportion in the widely monitored survey’s history. Reflecting this conviction, portfolio managers allocated an overweight position to bonds, the most in two decades, except for in December 2008 and March 2009, amid the financial crisis.
This would be the seventh instance since mid-2022 that the market projects the Fed to “pivot” towards lower short-term interest rates, according to a client note authored by Deutsche Bank macro strategist Henry Allen post the CPI announcement.
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“On the last six occasions, those expectations have been dashed, because inflation has been too strong for the Fed to be comfortable cutting rates,” he wrote.
Inflation has exceeded the central bank’s 2% target since the beginning of 2021, while the most recent summary of economic projections, issued in September, envisions another increase in December and only two reductions next year. This culminates in the average expectation that the fed-funds rate will stand at 5.1% by the end of 2024, surpassing the 4.38% midpoint projected by the futures market. The consistent theme of this rate cycle is that investors have prematurely postponed their expectations for a Fed rate cut and have been compelled to reschedule it in the future.
The exuberance in the market — the S&P 500 index has surged nearly 10% from its October low, and the yield on the influential 10-year Treasury has retreated by half a percentage point from its peak above 5% — indicates a “Goldilocks scenario,” in which inflation has abated and genuine growth remains robust, as per a report by Macro Intelligence 2 Partners, once again becoming the prevalent narrative.
However, with a softening in financial conditions, it is expected that the economy will experience a slight deceleration in the first quarter of the upcoming year, contradicting the Fed’s stated goal of further dampening inflation. Although it may seem cyclical, the decrease in bond yields, predicated on an anticipated Fed rate cut in 2024, could actually hinder Fed Chairman Jerome Powell and his fellow monetary-policy makers from reducing rates.
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Similarly, Robert Tipp, the chief investment strategist at PGIM Fixed Income, believes that persistent inflation above 2% will impede the Fed from implementing as many cuts as the market anticipates. Furthermore, continued Treasury borrowing necessities due to the “substantial” budget deficit will prevent significant declines in bond yields, as stated in an interview.
In particular, Tipp aims to “normalize” the yield curve, with long-term interest rates 50 to 100 basis points higher than short-term cash rates. So even with Fed cuts, bond investors should only anticipate returns from interest income, not from the value appreciation that accompanies a decrease in long-term Treasury yields, as estimated by fund managers in a BofA survey.
Instead, Tipp is emphasizing returns from corporate obligations, encompassing investment-grade and high-yield credit. Additionally, they favor high quality collateralized debt obligations. (CLOs divide a portfolio of corporate loans into tranches; the first tranche is paid off first and is the least risky, while successive loans yield higher returns commensurate with their greater risk.) Consequently, corporate credit, owing to heightened borrowing, is anticipated to outperform Treasuries, as per Tipp.
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The agreement clearly contradicts the market’s anticipated scenario of a substantial Fed rate cut of a full percentage point in the forthcoming year. Fixed income investors are advised to consider the relatively defensive funds highlighted in our October 30 bond-market cover story, which emphasize shorter durations and higher yields. Essentially, they should moderate their enthusiasm regarding further bond rallies.
message Randall W. Forsyth at [email protected]
Source: www.barrons.com
