We may have seen the last rate hike, but when will we see the first cut?

Entering 2024 it was widely believed that interest rate cuts were on the horizon, as policy makers set the tone at the December FOMC meeting by increasing their interest rate forecast to three cuts, previously at two for 2024.   Considering that any policy action was data dependent, this was initially accepted in a dovish manner by investors as the likelihood of rate hikes appeared to be over.  The fed funds futures market quickly adapted and priced in six rate cuts for 2024, the first as soon as March.  Following a period of unusually high inflation and rapid monetary policy tightening from March of 2022 to August of 2023, inflation has fallen significantly and has been hovering just above 3.0% in recent months.  

Meanwhile, the United States labor market remains extremely tight, considering the FOMC’s attempt was to lower inflation at the expense of ultimately slowing the economy and softening the employment picture.  As a surprise to the economy during this period of aggressive policy tightening, the unemployment rate has remained consistently below 4.0%.  As a result of lower than anticipated unemployment and still sticky inflation to start the year, market sentiment has changed regarding not only how many interest rate cuts we may see but also the timing of the first cut.  

Policy makers are now faced with the risk of easing monetary policy too soon, which could allow slightly above target inflation to soften even further than the 3.5% CPI in March, creating pricing pressure again.  Federal Reserve Governors’ Bostic, Waller, Kashkari, and Chair Powell have all recently commented that the economy remains strong, and the first quarter economic results could warrant delaying and/or reducing the number of rate cuts this year.  They are all concerned with disappointing inflation results in the first quarter coupled with robust hiring, providing the Fed flexibility to be patient with policy action in order for them to gain the confidence they need that inflation is back on path towards the long-term target rate of 2.0%.  Unfortunately, unless we have an accelerated weakness in the economy, the “higher for longer” scenario will likely hold, even more so as we get closer to the election, giving officials another reason to be patient.

Will Quantitative Tightening Change?

With all the focus being on the fed funds rate, it seems investors have forgotten about another tool the Fed has used for easing and tightening of monetary policy.  At an upcoming FOMC meeting it is likely that a modification will be made to “Quantitative Tightening.”   The Fed’s investment portfolio size has declined since June of 2022 by nearly $1.5 trillion.  At the moment, the Fed is considering when and how much tapering of the roll-off is needed.   They are trying to avoid a similar event that happened in 2019, when there was a shortage of short-term U.S. Treasuries in the funding markets.  This caused overnight repurchase rates to rise, adding stress to funding markets and Wall Street positioning of inventory.  Currently, the Fed is allowing up to $60 billion of U.S. Treasures and $35 billion of Agency MBS to mature or roll off from principal payments on a monthly basis.  With the rise in interest rates over the last 2 years, prepayment speeds on mortgages have plummeted and the monthly amount of roll off has not come close to exceeding the monthly cap of $35 billion.  Fed officials have historically commented that if possible, they have a preference towards a Treasury only portfolio, however, it is unlikely they will sell MBS into the market.  We also believe that they will continue to let MBS roll off their balance sheet in accordance with the monthly principal and interest payments.  Where there could be a change, though, is in the Treasury holdings.  They are considering lowering the monthly cap, which would allow them to reinvest the additional cash proceeds of maturing securities above the new cap level back into short term Treasury Bills.  This would assist with the collateral shortage in funding markets as the Fed’s balance sheet is a direct source for collateral in the repurchase market.  Unlike other scenarios when the Fed had been purchasing bonds during QE periods, such short duration securities would have a minimal impact to longer term interest rates, but would help enhance liquidity in the funding markets. 

Investment Opportunities

The long-term forecast from virtually all economists still calls for lower rates, regardless of the timing of the first cut.   With the recent back-up in rates to start the second quarter, there continue to be opportunities to add accretive yield to existing balance sheets.  The recent stronger than anticipated data supports the “higher for longer” scenario, as the ten-year Treasury has risen back above 4.50%.  This level of rates has created another opportunity to add accretive yields that would enhance the book yields of current investment portfolios.   

Agency (FNMA/FHLMC) CMO floaters are currently offered with a spread to SOFR of more than 120 basis points.  This yield compares favorably to other AAA rated assets, with a positive spread to SOFR projected under all interest rate scenarios.  In the base case, the floater’s average life is approximately 5 years, which helps mitigate duration risk for interest rate sensitive balance sheets.  Agency MBS also offer attractive yields, and have the potential for price appreciation as rates decline.  With the recent back-up in rates, discount priced MBS are available with more than 50 basis points of price protection before prepays are likely to increase.  Additionally, discount to par MBS will prepay slower than current coupon securities in an environment headed towards lower interest rates, allowing investors to lock in attractive yields for an extended period.  Investment grade credit spreads continue to remain below long-term historical averages, and at this time do not offer a worthwhile risk-return trade off.   Comparably, Municipal bond spreads also remain below historical averages due to demand for longer term call protection in an inverted yield curve environment.