WEEK ENDING 1/24/2025
- The fear and the opportunity of high interest rates.
- Fed meets Wednesday for the first time this year.
- Here come the tariffs.
A CITY DIFFERENT TAKE
Over the weekend, Barron’s published an op-ed titled “High Interest Rates Loom Large.” The piece talks about rising interest rates casting a shadow over the stock and bond markets. Let’s address the fear of high interest rates and how fixed income investors should best position themselves in this environment.
We’ll start with the premise that interest rates are notoriously hard to forecast. We would argue, however, that the current environment is ripe with opportunity if you actively manage your fixed income portfolios.
A quick recap of last year: The Fed cut interest rates by 50 basis points in September, followed by two 25-basis-point cuts in Q4. In total, the Fed cut interest rates by 100 basis points, bringing the Fed Funds rate into a band of 4.25%–4.50%. Counteracting this in Q4 of last year was a 100-basis-point yield rally in 10-year Treasury bonds.
Here’s what we know for sure (and for now) in terms of the Fed’s dual mandate with full employment and 2% inflation:
- We saw strong labor market numbers in December’s non-farm payroll release.
- Inflation is at 2.8% (according to November’s Core PCE), which does not yet meet the Fed’s 2% target.
The Treasury curve has been positive since Q3 of last year and has steepened into Q4. Higher-term premiums are demanded for the longer tenors to compensate for the uncertainty in tax, immigration, and tariff policies. In light of that, we have seen real rates turn positive. Real rates are nominal rates minus inflation.
The chart above shows that the one-year and five-year parts of the curve are showing value in terms of real rates even when we look at them in the context of historical averages. The 1-year historical average is 70 basis points, with the current 1-year real rate at 1.36%. Similarly, the 5-year real rate at 1.62% looks attractive compared to its historical average of 1.39%. The 10-year part of the curve must rise higher in yield to look compelling from a historical perspective.
We would argue that being overweight in the 1-year and 5-year parts of the curve and optimizing curve allocation is an active investor’s friend. Also, as rates rise, and the curve steepens, the 10-year part would revert to historical averages.
In addition to curve allocation, active ladder management is also beneficial in this environment. A laddered portfolio takes advantage of reinvesting at higher rates as maturity bands in the ladder come up for reinvestment.
Rates are notoriously hard to predict, and many a decent career has been sacrificed at the altar of interest rate prediction. In terms of rates, higher-for-longer can be viewed as a recipe for buying bonds on sale. Opportunistic curve positioning and reinvesting using a ladder strategy are key here.
The other part of this equation is when rates fall. Rates could fall based on economic weakness, black swan events, slowdown in labor, etc. In that scenario, avoiding the bond market would leave you completely out of the money.
This week marks the Federal Reserve's first meeting in 2025. Markets have priced a 100% chance of no rate cut. The Fed has seen both employment and CPI numbers. What it must now digest are the new administration’s tariff and immigration policies and their impact on the economy.
CHANGES IN RATES
Rates in the Treasury market did not move much week over week.
Interest rates in the municipal market also declined last week
The muni-Treasury ratio tightened even further, making munis richer.
Corporate yields trended lower over the week.
THIS WEEK IN WASHINGTON
Let’s start with incoming tariffs. Over the weekend, President Trump ordered 25% tariffs against Colombia, which could increase to 50% in a week. The market then anticipated a 10% weakness in the Colombian peso. This caused S&P futures to waver, as the market absorbed this news. The tariffs were ordered after President Gustavo Petro refused to allow two military planes carrying deported migrants to land. On Sunday, the two countries reached a deal on deportations, which put tariffs and sanctions on hold.
The U.S. will also review its Economic and Trade Agreement with China. This is to understand if China has been following the agreement in its policies. Negative findings could lead to Trump enacting tariffs on China. As a result of the review, the corporate bond market has halted its spread tightening.
In cabinet confirmations over the weekend, the latest noteworthy nominee is Kristi Noem. Tasked with executing the president’s immigration crackdown, Ms. Noem joins Treasury Secretary Scott Bessent as the latest addition to Trump’s cabinet. And one of the most controversial nominees, Pete Hegseth, was confirmed and sworn in following a tie-breaking vote from Vice President Vance.
WHAT, ME WORRY ABOUT INFLATION?
The 5-year Breakeven Inflation Rate finished the week of Jan. 26 at 2.34%, 4 basis points higher than Jan. 17. The 10-year Breakeven Inflation Rate finished the week at 2.43%, 2 basis points higher than Jan. 17.
MUNICIPAL CREDIT
As of Jan. 24, 10-year quality spreads (AAA vs. BBB) were 0.88%, unchanged from the prior week (based on our calculations). The long-term average is 1.69%.
Quality spreads in the taxable market are not attractive. They ended the week at 0.83%, 1 basis point tighter than the prior week. High-yield quality spreads were 4 basis points wider at 2.50% week-over-week.
WHERE ARE FIXED-INCOME INVESTORS PUTTING THEIR CASH?
Money Market Flows (millions of dollars)
Overall, money market funds saw an increase in inflows compared to the week prior.
Mutual Fund Flows (millions of dollars)
Cash flows into bond funds were mixed week-over-week across categories.
ETF Fund Flows (millions of dollars)
ETF asset classes experienced positive net flows, with a drop in municipal activity.
SUPPLY OF NEW ISSUE MUNICIPAL BONDS
The supply of new issues is expected to be closer to $5.9 billion this coming week. The annual average is approximately $11 billion.
CONCLUSION
While the fear of rising rates is worrisome, know that interest rate prediction is not for the faint of heart and is tricky at best. We can prepare to take advantage of rising rates with active curve positioning and laddered strategies. The Federal Reserve meets this week to discuss policy rates which we anticipate will be left at status quo.
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