Jackson Hole Takeaways: A Fixed Income Perspective

Hello everyone. Welcome to another episode of Understanding Edge, brought to you by Diamond Hill. I'm Jessica Schmitt, Director of Investment Communications, and today I'm joined by Douglas Gimple, our firm's Senior Portfolio Specialist for fixed income.

In today's episode, we'll discuss themes and takeaways from the Jackson Hole Economic Symposium. We'll also discuss bond market's recent performance and risks and opportunities for investors going.

Whether you are a regular listener or tuning in for the first time, we hope this episode offers valuable insights. So, sit back, grab that cup of coffee or tea, and let's get started. Thank you for tuning in, and I hope you enjoy this conversation with Douglas Gimple.

Hey, Doug, great to have you back on the podcast.

Thanks, Jess, for having me on as always. It's a pleasure to be here.

Well, great. Let's get started and we're going to talk about some of the main themes that emerged from the Jackson Hole meeting last week. Clearly, inflation and the labor market are two key data points that the Fed watches very closely. Can you share with us what the meeting revealed about the Fed's current view on those particular data points, as well as their expected trajectory and the implication to future rate cuts?

Yeah, so on these podcasts, we always recap what happened with the Fed, whether it was a meeting or whether it's Jackson Hole since there wasn't an official meeting since we last spoke. And so, looking at what happened at Jackson Hole and the speech, we actually have something interesting to talk about because the last several meetings were just stay the course, data dependent and nothing is happening.

And I want to throw in a quote from Powell right at the end of his, or maybe it was the middle of his press conference, where he said “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.” So this is their, hey, we're here now. It's been a little over a year into the most aggressive tightening campaign that we've ever seen: 525 basis points of rate increases over, again, like a year and a month. And so very clear indication that September is a go for the first rate cut.

It's been nearly two years to the day when Powell spoke about his readiness to accept pain, for everyone else, I guess. A recession that would bring inflation under control. Well, it feels like they've avoided that outcome and we are getting closer to this soft landing. The shift that we saw, the focus has really been on inflation and getting that under control because at the same time, the labor market was doing fairly well. We were creating jobs, unemployment was, for the most part, sub 4%. Now we're getting back to that dual mandate of price control and the labor market. And so, we've got the highest level of unemployment at 4.3% is the highest level in three years. But relative to history and what's deemed the natural level of unemployment, still pretty good. But it has raised that answer, I guess, that now is the time. But the question becomes: Is it 25 basis points or is it 50 basis points in September? And it's really going to come down to the incoming data, whether it's going to be inflation or another jobs report. We did have the adjustment of non-farm payroll from March to April of last year that basically trimmed 800,000 jobs off of job production, but that will be revised again. And it was kind of in line with expectations. It lowered the number of jobs per month that were added from, I think, 254 to 177. So, still strong production of jobs.

The Fed’s held the line despite all the calls and the expectations for lowered rates. And even during the volatile period, early August when people were calling for intermediate cuts and saying, hey, we need to get ahead of this. But they've held the line. And so, again, the question becomes 25 or 50? Given the history of the Fed, it's really going to be what they've talked about continually, which is data dependency.

And I look at something like 2015 to 2018 and maybe a reverse of that. And what I mean by that is, at that time, we were raising rates, but we were raising rates very, very cautiously. 25 basis points at the end of 2015, 25 basis points at the end of 2016, and then 75 basis points in 2017 and a hundred basis points in 2018. Could we see a reverse of that where we are very gradually cutting rates? And that's all going to depend on data, and they're giving them, they're giving themselves that flexibility to adjust on the fly, whereas the market is being very aggressive in where they think rates are going.

The last thing I would mention is we didn't get it at Jackson Hole but at the end of September meeting, which I believe is on the 18th, we are going to get the new statement of economic projections, and that's the famous dot plot, which is going to give us insight into the Fed's thoughts on the future path of rates. But that chart ages immediately because you have incoming data that's going to change the outlook, but it is going to give us an understanding of their long-term thinking and the impact of what that data has done on that outlook.

And Doug, you mentioned it briefly, but what is the market expecting for September? Are we way out of line from the 25 to 50 bps that the Fed is more likely to do? We've talked about this a lot in the past.

Yeah, it's interesting when you look at it, 25 basis points was a given pre-meeting, with maybe call it like a 25% chance of 50 basis points. After the meeting, it was basically a 35% chance of 50 basis points. So, the market, at least for September, is right in between: it’s a given that it's a 25 and a kind of moving between, call it 25% to 35% chance that it's going to be 50. Now as we get more data, I think that's when we're going to get clarity, at least from how the market is pricing it and possibly how the Fed's thinking about it. Through speeches and interviews, they'll get us closer to understanding exactly where they're going as we get closer to that meeting. Now, we'll have the blackout period, which is a week before the meeting, but I would imagine the roadmap's been laid out well before that blackout period based on, again, we'll have non-farm payroll at the beginning of September, we'll have CPI. So, it's going to give all of us a better understanding. That being said, to your point, Jess, it feels like the market's a little bit out over their skis in leaning a little bit more towards that 50 instead of just the straight 25.

Okay. Well, we'll find out in September. I was going to ask Doug if there were notable shifts in the Fed's commentary. Obviously, there was. And what kind of immediate or long-term effects do those shifts have for fixed income investors?

Well, the impact is going to be a little bit longer term, but the benefit of if you have duration, which is this is almost the opposite of 2022, where if you had duration and it was longer duration, it was going to hurt a lot. Now, if you have duration, longer or shorter, this should help as rates come down.

What's interesting is if you look at the 10-year Treasury, it ended 2023 at right around 3.88%. Currently, and this is August 26th when we're recording this, currently the 10-year yield is around 3.81%. So essentially unchanged since the beginning of the year, keeping in mind that it got as high as 4.7% in late spring. And you compare that to the 2-year Treasury, which has followed a similar path, but it is reflecting that 25 basis points of easing because it was 4.25% at year-end 2023, and it's currently at around 3.92%. So kind of pricing in that 25 basis points on the 2-year, even though we pushed past 5% in late spring on the 2-year Treasury.

So, you have these shifts, but for clients, for investors, the idea of a dovish Fed, of an easing Fed is beneficial to fixed income because you already have your income because of higher coupons. Now, if rates come down a little bit, you're going to get that principal appreciation as well. But going back to that dispersion between the Fed and the markets, the market's pricing in, if you look at Fed fund futures 3.07% by year-end 2025, which is very aggressive, and if we look at the Fed's most recent dot plot, which again is already antiquated, it was calling for I think 4.25% or 4.22%. So a very big difference there, the impact and potential impact for fixed income investors is as the market gets in line with the Fed, we could see instances like we saw in the first quarter and second quarter of this year where that disconnect created a lot of volatility in the Treasury market. I think we're going to have a lot more clarity, and again, that roadmap from the Fed, so it maybe won't be as volatile, but that is something to keep an eye on as the market gets in line with the Fed as to where the Fed believes they're headed. You could see some bumps in the road.

And what kind of reaction did we see in fixed income markets as a result of Powell's comments at Jackson Hole?

Yeah, it was pretty muted, really. I mean, we didn't see significant shifts in the Treasury market. I know the equity markets rallied. That's not my area of expertise, which you would expect, again, a more dovish Fed, but really I think the story in August outside of maybe the shift from Jackson Hole to more dovish is that volatility that hit the markets right after the non-farm payroll, which was combined with the Bank of Japan raising rates and the unwinding of the yen carry trade, all of that created a lot more volatility. We saw it in the equity markets; we saw it in the fixed income markets. We saw it with corporate spreads widened out call it 15 to 25 basis points. Securitized market widened out a little bit, but tends to lag. And by the time it would've been widening to catch up, things had stabilized.

So, it was really, I think the volatility in August wasn't really associated with the Fed because people expected it. It was much more with the early part of the month, we saw the VIX, which is that measure of market volatility. Intraday hit, I think, 65, and it hadn't been that high since the early days of COVID, but corrected almost, I wouldn't say almost immediately, but corrected within probably five or six days. That was, I think, more the really encompassing story of August rather than what we saw at the Fed in Jackson Hole was because it's kind of what we expected at Jackson Hole, whereas the other stuff earlier in the month was completely unexpected.

And certainly, Jackson Hole is what people have been wanting for a long time, seems like?

Yeah. It's finally getting, and I think to a certain degree, finally getting the market what they want, because as we've talked about early in the year, the market wanted just a ton of easing by year-end, and the Fed stuck to the script and said, no, we're not doing it. We don't see a reason to cut rates as aggressively as what the market was saying. And so we've gotten in line with that, but even then, the amount of easing is still, there's a little bit of disparity there.

We'll know more as the days go on. Let's transition over to your latest monthly commentary, Doug, and you focused on recession indicators, and you explored some of the well-known indicators, like consecutive quarters of negative GDP, but also some of the lesser-known ones. And I think most importantly, at the end of the commentary you had stated, “as investors, it's not our job to determine whether the economy is officially in a recession.” And, of course, you go on to share what our team here at Diamond Hill does focus on, which is bottom-up security selection. So, help us understand what do you think investors should be focused on as we head into the remaining months of 2024? Of course, we have an upcoming election, and then beyond that?

What I would say to investors is focus on your portfolio, whether it's equities or fixed or alternatives, and understand where the risks reside. Everyone listening to this podcast is most likely invested differently. So the most important thing is to understand what you own and what risks you have assumed. More broadly the focus is going to be on, it's no surprise, the Fed and how they navigate the upcoming economic data and direct the markets as to which direction they're going, or I guess I would say with what velocity they're going in that direction. But there are other things that have to be taken into account, whether it's the geopolitical tensions in the Middle East, Russia-Ukraine, China-Taiwan, as you mentioned, Jess, the upcoming US election, as I pointed out in the commentary and we talk about quite a bit, we're not here to predict what direction rates will go and invest accordingly.

We're also not here to predict how the markets are going to move and what each data point for the economy is going to do to the markets. But it is important to understand how each of these inputs — whether rates, spreads politics, economic data, whatever it is — how it impacts our investments in the investments of our clients. Who knew that we'd see the volatility that we were just talking about that we experienced in early August as that yen carry trade unwound and equity markets really got knocked around a bit. Interest rate risk is a huge part of the investment profile for fixed income in general, but it's not the only component. And finding opportunities in an inefficient market can lead to some compelling relative returns, and that's what we focus on: value with the appropriate level of risk in a broadly diversified portfolio.

And so, Doug, you mentioned some of these potential wildcards, but my next question was what are wild cards or uncertainties that could impact fixed income markets and investors over the coming 6 to 12 months?

We get that question a lot, Jess, and I will admit it's almost impossible to answer because if I knew the wild cards and the uncertainties, thus making them certain, I'd be sitting on a beach somewhere just rolling my money around. But there are things to keep an eye on that provide some insight for understanding the markets. The obvious are the economic data points that we discuss all the time, labor, CPI, productivity, all of those different things that the Fed and the markets are watching closely. But the other wildcards are things that we discussed earlier that are more global in nature but can impact us here at home. The actions of the Bank of Japan sparked the market turmoil earlier in the month, a resurgent Ukraine taking the fight to Russia. Russia retaliating in the news today with a missile strike throughout Ukraine. China, saber-rattling in the South China Sea with Taiwan. The potential for more widespread unrest in the Middle East. These are all things that can affect the markets and everyday life and even the emergence of MPox, which is the virus formerly known as Monkeypox, is making headlines across the globe with countries now monitoring their borders for any sign of incursion, which probably gives people a lot of PTSD about COVID. I don't think we're there. I don't think it's, it's not as threatening as COVID, but it is something that you hear more and more about.

So, it's all of these things that we just, and you know what? I just named a bunch of things, and I can almost guarantee you it's something we aren't even thinking about that's going to be the next thing that unhinges the markets. That's always how it works, it’s the things you never expected that suddenly pop up. And that's why it's called a black swan event and an uncertainty. But those are the things that we can keep an eye on. We can think about how they impact our portfolios, our market, but we've always got to be on the lookout for the canary in the coal mine, if you will, and whatever that may be.

And I think, Doug, that going back to something you said earlier really underscores your point about knowing what you own and knowing how it could potentially react to some kind of uncertainty that we don't know about yet. Right?

That's exactly right. It's just you're better off having a good understanding of what you own so you can better prepare yourself for what those risks may be, rather than being invested in some kind of black box where “trust us, this is what your portfolio should do.” And then you find out, well, maybe that's not really the fact. Again, I tend to be a little bit more old-fashioned, but for fixed income especially, I think you want that stability and predictability when you're looking at your investments.

And Doug, so arguably more importantly, aside from the risks, what opportunities do you and the team here at Diamond Hill see in the current environment for fixed income investors?

I think obviously it's going to depend on some factors, but opportunity-wise, I look at again, and I know I keep coming back to it, but the volatility of early August, that's an opportunity. As investment firms were liquidating to cover whatever yen carry trade or whatever they had been doing, they're selling high-quality fixed income, for example. That's a great opportunity for us to provide that liquidity to them because we weren't investing in the yen carry trade or any of these areas that started to get disconnected. But I think it really is going to depend upon the speed at which the Fed moves, how well they communicate, that will reveal the opportunities.

But when we look at specifics, the commercial real estate market, which as we've discussed quite a few times, has just been reeling over the past few years. It's going to benefit from lower rates, but it's going to take a while for the impact to work its way into the system. It doesn't happen overnight. So as the Fed starts this easing process, just the idea that they've started is going to help the commercial real estate market.

A lot of issuers, a lot of borrowers had taken on the mantra of just survive until 2025 with the understanding that we'll be feeling the rate cuts and we'll be able to refinance and all these different aspects that go with the commercial real estate market. But you're still finding mispriced securities that have very good underwriting, solid collateral and a good story that presents an opportunity if you're willing to do the work and understand what you own. As lower rates work their way into the system, homeowners that, unfortunately for them, bit the bullet and bought new homes over the last couple of years at significantly higher rates, you would imagine they're going to be jumping at the opportunity to refinance and lower their monthly expenditures. If they had a mortgage, let's say 5% or 4%, they don't want to refinance at 7.5% or 8%. So, they're going to take a home equity line at 9%, but still hold onto that original mortgage rate. So they get access to the equity, they're paying a little bit more, but blended, it's not as bad as if they refinanced the whole thing. As we see lower rates work their way into the system, we're going to see homeowners refinance that's going to help mortgage companies, that should help the housing market because you've got lower rates, there's a lower hurdle to get into a new home.

For those that had what were called golden handcuffs, which basically I have a low mortgage, I don't want to move because I don't want to then pay three times what my mortgage rate is on the new home. So a lot of that should come undone in a good way to where you'll see more activity. But most importantly, during periods of volatility like we saw earlier in the month, investors that are patient, willing to provide liquidity for those that are panicking or feeling the need to liquidate at what would be an inopportune time, we stand to benefit quite a bit.

Okay. Well, great Doug. That's all the questions I have. Do you have any final thoughts for our listeners today?

No, I think we've been through it. We've come through a really tough time. Through 2021 negative returns in fixed income, 2022 historically negative returns in fixed income, and even the first part of the first 9-10 months of 2023 negative, and really November-December saving the calendar year for positive performance. And even, I guess I would say the beginning of this year, negative performance in fixed income. It feels like we've kind of gotten over the hill and we should see, and we have seen positive fixed income kind of back to where we should be. And if we do see the Fed continuing on this dovish path, more and more opportunity for the returns that we would normally expect in fixed income and for fixed income to behave as it historically has. So, I think the message for listeners is stay the course. Make sure you understand what you own, try to mitigate your surprises and take advantage when you can when you see those opportunities in the fixed income markets.

Okay. Well, thank you so much, Doug. Before we go, I'll mention a couple of upcoming events: On September 10th at 2:00 PM Eastern Time. Doug, you'll be joining Todd Rosenbluth, head of research at VettaFi, for a live webinar where you guys are going to explore what's been driving volatility in fixed income markets this year, provide any update on Fed policy beyond what we've talked about here, of course, thoughts about spreads, and of course, more various topics on fixed income. So, for our listeners, please check out our website for registration details. Those are live now. And, of course, Doug and I will be back for another podcast next month after the Fed meeting. So Doug, again, thank you so much for joining us. It's always a pleasure to have you.

Thanks, Jess. I love being here. So the more times we do it, the merrier.

Alright, well great. For more insights and a full download of Doug's latest market commentary on fixed income markets, visit our website at www.diamond-hill.com. And until next time, take care.