We Part Ways With Consensus
Our rates outlook is now out of consensus. We disagree with the current futures market pricing and expect consecutive 25 bp cuts, starting from the Fed’s June meeting. Two months ago, most agreed with this assessment; however, now, we appear to be standing alone.
As the markets continue to reprice, persistent inflation is orchestrating a steady uptick in yields. The US Federal Reserve’s (Fed’s) task of aligning yield curves with expectations of 2% inflation, amid its stringent monetary policy, remains arduous, even as the personal consumption expenditures (PCE) measure has declined at a steady pace, currently at 2.4% year-over-year.
Against this backdrop, we observe a downward trend in most inflation measures (CPI, PCE); yet Fed officials remain cautious in their assessments.
Our outlook includes an aggressive call on the Fed. We expect consecutive 25-basis-point (bp) cuts (one per meeting from June until December ), leaving the policy rate between a range of 4.00% to 4.25% by year’s end. Two months ago, most agreed with this assessment; however, now, we appear to be standing alone.
At the time of this writing The Fed Funds futures market reflects a policy rate of 4.49% by the December FOMC meeting, though this rate has fluctuated over the last four months, in a range between 3.65% and 4.79%. It underscores the uncertainty inherent in the Fed Funds futures market. It is a perennial truth that the futures market often veers off course.
The current positioning of money market funds leans toward long durations, aiming to target the point just shy of where the yield curve inverts so as not to dilute the current yield and be fooled by the mispricing of the term premium.
Meanwhile, Treasury Bills remain attractively priced, whereas discount notes offer limited value. We recognized the inherent seasonal shortage of T-Bills in the spring months as tax payments leave the US Treasury flush Commercial paper (CP) appears rich compared to the levels over the past year. We remain cautious on credit given the expectation that recessionary pricing has yet to arrive. Prime MMF yields stand at approximately 15 bp over government MMF yields, slightly tighter than the past one-year average of 18 bp.
Overall, MMF flows exhibit notable strength, and we continue to see record levels of total assets under management in MMFs.
The upcoming March meeting carries significant weight, particularly as discussions revolve around the tapering of quantitative tightening (QT). Fed Chair Jerome Powell’s remarks during the January Federal Open Market Committee press conference made it clear that a policy easing is not on the table for the March meeting. As a result, our attention is focused on the potential reduction in QT.
It is anticipated that there will be no change in the amount of Mortgage-Backed Securities (MBS) that roll off the Federal Reserve’s balance sheet. Fed allows up to $35 billion of MBS to roll off each month, with the objective of gradually eliminating its MBS holdings.
Though we do not expect a change in approach to MBS holdings, we do anticipate a reduction in the amount of US Treasuries that roll off the balance sheet. There is an expectation that the volume of Treasuries rolling off will decrease, potentially by around $30 billion. This adjustment reflects the Fed’s ongoing efforts to gradually normalize its balance sheet while carefully managing market expectations and economic conditions.
In essence, as we navigate through the turbulence of market repositioning, it is imperative to remain vigilant and adaptable, recognizing the nuanced signals amid the noise.