“If you can keep your head when all about you are losing theirs and blaming it on you...” Rudyard Kipling
Yesterday, I noticed Warren Buffet was in the press quoting this Kipling piece, one of my favorites, and I thought it was sound advice, especially in these volatile markets. We (the CDI team) would like to take a few moments to recap the market-moving events post “Liberation Day” tariff announcements. First, we should get some of the basics out of the way:
The fixed-income team at CDI believes tariffs:
- Are a tax on the consumer
- Will add to inflationary pressures
- Will ignite a trade war (China has already counter-punched with 34% reciprocal tariffs).
The old saying, “Do not beggar thy neighbor,” comes to mind. Wikipedia defines the phrase as “an economic policy through which one country attempts to remedy its economic problems by means that tend to worsen the economic problems of other countries.” In our estimation, fear has been the major driving force in equity and bond market volatility over the last few weeks.
The CDI fixed income team relies on three value metrics to arrive at its decision to invest and where to invest.
- Real Yields (security yield less inflation measure)
The recent rally in the Treasury market has significantly reduced the “real yields” of Treasury securities across the maturity spectrum. The Core US Personal Consumption Expenditure Index has proven sticky; 4 of the last 5 readings are at 2.8%.
“More certain is that Mr. Trump's tariffs will boost inflation,” noted Gregory Daco, chief economist at EY. “Consumer prices could accelerate by 1 percentage point by year-end, he added, which would boost the inflation rate close to 4% from its current level.”
The last Year-over-year CPI reading was 2.8% (in line with core PCE). The following table calculates the “real yields for several Treasury tenors.
Our current estimate of Treasury real yields is not even close to their long-term averages. For those so inclined, these real yield estimates are between -0.37 through -1.07 standard deviations and their long-term averages, which means that, in English, they are very rich. Again, more evidence that fear is driving the Treasury market not economic fundamentals.
- The slope of the Yield Curve:
The slope of the Treasury curve is measured by the yield difference between the 2-year maturity and the 10-year maturity. On 4/1/2025 that spread was 0.30%, as of this writing the spreads were 0.37%. The 20-year average is 1.34%. The conclusion is the Yield curve is very flat, so we will continue to focus on the shorter end of our strategies investment horizons.
- Relative Value:
Even with the rally in Treasury prices (lower yields), an investor still gets approximately 92% of the yield of a 10-year Treasury bond from a 5-year Treasury bond with only about 50% of the duration risk. Now, that is still value.
What will the Federal Reserve do?
The current Bloomberg World Interest Rate Probability Function estimates the Fed will cut short-term rates by over 1.25% by 12/31/2025, with probabilities ranging from 47.1% to 104.7%. Last month, three 0.25% cuts were the estimate de Jour. We think these current estimates are overdone (another sign of fear). The Fed has a dual mandate: Price stability (inflation) and Maximum sustainable employment. CDI estimates (as do many economists) that inflation is rising due to the Trump Tariffs and our trading partners’ reaction to them (just look at China). The economy looks stable given today’s employment report (+228,000 versus +130,000 estimate). But this reading does not capture the federal workforce reduction efforts, maybe next month. But as mentioned before, inflation is on the rise. What is the Fed to do? How about nothing, until the hard data shows significant weakness.
Conclusion:
Due to the above analysis, CDI’s fixed income team will be cautious before committing significant assets to the taxable market. The municipal market is another question. The municipal market is suffering from a seasonal spike in new issuance, which may provide some opportunities.
For those clients that have well-diversified portfolios, take solace in the fact that diversification has its benefits. For those clients that are not well-diversified, have patience. In times like these, besides drawing from Rudyard Kipling, I always think of my old boss, Ian MacKinnon, who counseled the managers he oversaw with these words:
“Fear is not an investment strategy:”
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