Decoding the Fed's 50 Basis Point Cut: Implications for Fixed Income

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 the latest action by the Federal Reserve and its implications for fixed-income markets. We'll also discuss risks and opportunities for investors going forward.

Whether you're a regular listener or tuning in for the first time, we hope this episode offers valuable insights. So, sit back, grab a 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.

Hi, Doug. Welcome back to the podcast.

Thanks, Jess, as always, for having me. It's a pleasure being here.

Great! Let's talk about this week's FOMC meeting, which is the big news that occurred yesterday on September 18th. Today is September 19th. The Fed was widely expected to announce the first rate cut, which comes on the heels of 11 hikes in 16 months that left the fed funds rate at a relatively high level for more than a year — higher than most folks are used to in quite some time. Of course, how large this first cut would be was hotly debated among market participants for the last month and a half. And we know now, Doug, that the Fed cut rates by 50 basis points. So, what was your initial reaction to Federal Chairman Jerome Powell's message in conjunction with this rate cut? And if you could share other takeaways that you think are relevant, especially for fixed income investors.

So, we've got the beginning of our easing cycle, which is something the market's been demanding, some would say, begging for quite a while, but the Fed has been reluctant to really get started. What's most interesting about this meeting was it was the first one in a really long time where we didn't really know what they were going to do. Sure, there were so many talking heads all over financial news networks spouting off about what they thought the Fed should and would do. But no one, except the Fed, really knew, and the ones that were stating that it was going to be 50 basis points are celebrating a bit and doing their victory lap. But you know they didn't know any better than anyone else. They just guessed right.

So, what are some of the key takeaways from this most recent meeting? One, the Fed had its first dissension since 2022, which at that time was Fed President Esther George, and it was the first from a Fed Governor since 2005. The dissension was courtesy of Federal Reserve Governor Michelle Bowman, who wanted a 25-basis point cut instead of the 50 basis points that we got. This broke a streak of 17 consecutive, unanimous meetings.

Is this a big deal? No, it's just one more takeaway from the meeting that maybe they all weren't in line. And it's as I said, it's the first time in 17 meetings. The other major takeaway was the shift in the dot plot and the subsequent dislocation with the market. So, there's a lot of numbers here, but I'll run through them as quickly as I can.

So, the year-end 2024 projection from the Fed dropped 75 basis points from where it was in June when we last got a dot plot of 5.125% to 4.375%. So roughly, the 4.25% to 4.50% range. And that's a level that implies two additional 25 basis point cuts by the end of the year. Now we've got two meetings. We've got November 7th and December 18th. So, two meetings, 25 basis points.

This conflicts with the market expectations, both before the meeting and after the meeting, for a year-end level in the 4.00% to 4.25% range — roughly 75 basis points in cuts. So right there, by the end of this year, which is not that far away, you've got a 25-basis point difference between what the market is pricing in and what the Fed has expected or is expected to do, based on their own projections.

The 2025 year-end projections also showed a drop of 75 basis points from 4.125% to 3.375%. Or again, that range of 3.25% to 3.50% because they always talk in ranges now. This projection implies a reduction of about 100 basis points in 2025. But futures are pricing in, you know, roughly 125 basis points of cuts in 2025.

So, there's still this disconnect between the Fed and the markets. But now it's around kind of how quickly we get to what is neutral, which would be that rate in which the Fed's neither helping nor hurting. Market reaction was muted initially. Not a lot of reaction at all when we looked at the Treasury curve. But by the end of the day and into today, which is Thursday, the long end of the Treasury market has sold off, which reflects kind of the market's disappointment, if you will, not in the size of the cut, but rather what came after, and the Fed's expectation for the future path to neutral.

The Fed appears to be taking a more measured approach, which, frankly, is what I would expect while the market wants more sooner. In his press conference, Powell was quite clear that there's no rush and that this should not be considered the new pace going forward — that everyone should think of rate cuts now in 50 basis point increments. But rather, it's just a bigger start to a more measured approach going forward, and of course, data dependent.

Okay, so it's safe to say the Fed's held its line effectively, right? Data dependent. We've heard that time and time again. And really, like you said Doug, this is more of a question of pace versus anything else, depending on the data.

Right. They held the line. Now, the 50 instead of 25 is maybe them conceding a little bit, and they talked about the employment situation, and how things had kind of not even turned the corner. But they've just been less productive these last three months from a job growth standpoint. But they've definitely held the line. And I think that his comments afterward, the verbiage in the statement, just reinforces that they're going to continue to do, in your words, hold the line, and this is what we expect is going to happen, barring any extraneous impacts on the market.

Well, let's talk a little bit about the implications of a declining rate environment on various parts of the fixed income market. So, of course, it's still debatable, like we said, the pace and timing of additional cuts, but starting with the mortgage market, which has both commercial and residential, has been in the news for quite some time now. What do you think investors should expect to see in both areas, commercial and residential, now that we've had this initial rate cut?

Well, if we consider the neutral rate, the rate at which Fed policy is, as I mentioned earlier, neither holding back nor stimulating growth, we expect that to be in the 2.50% to 3.00% range. Even that reduction of 50 basis points to the new level of call it 4.75% to 5.00% means the economy is still significantly above the neutral rate. The launch of this easing cycle does provide good news for the mortgage markets. No doubt, both commercial and residential. Policy is now less restrictive than it had been, and we're en route to more easing, which is a step forward for more supportive financial conditions, which will be positive in the long run for commercial real estate fundamentals, cash flows and underwriting.

50 basis points is definitely kind of that incentive for money that's been on the sidelines and worried about both residential and commercial markets to jump back in, which is good for everyone. Outside of the rate cut, we've seen some positive developments in commercial real estate, as a year-over-year decline in sales volume has stabilized. REIT stocks are rebounding, banks are easing lending standards, and issuance in private-label CMBS (commercial real estate) is ramping up once more. It's up about 160% through the second quarter of 2024 versus a year ago. So again, maybe a little bit of thawing. But it's going to take quite a bit longer. But maybe we're turning that corner.

In the residential mortgage market. The rate reduction is going to help both current homeowners and prospective homeowners. Homeowners that bought prior to 2023 are going to find it cheaper to access the equity that's built up in their home due to that run-up in housing prices that we've heard so much about, whether it's through home equity lines of credit, or other methods of accessing that equity they now have in their home. It's going to get cheaper. Homeowners that bought in 2023, and even 2024, at least early 2024, could potentially have the opportunity to refinance into a lower rate, if not now or in the coming weeks, then definitely, as we move forward as the Fed continues on this easing path.

There does remain a gap between homeowners that are basking in rising home prices and wanna-be home buyers that still just can't afford a home. And you know, when we think about it, Jess, mortgage rates are only one part of that housing equation. Mortgage rates — we've been talking about it — as those are coming down, and they have come down. They peaked just north of 8%. Now they're in the kind of 6% to 6.25% — that will continue to come down. But other parts of that equation: insurance, that's rising. You see articles and anecdotes repeatedly about homeowners’ insurance going up and pricing people out of homes. Home taxes are going up because of the appreciation in home value. The reduced inventory is driving prices higher.

So yes, mortgage rates coming down, that's going to help. But there are other parts of that equation that are still going to make it challenging for those that don't own a home and are looking for their first home to really take that step. According to Moody's, mortgage rates probably have to get down to call it 5.25% for a mortgage payment on a medium-priced home to be cheaper than rent. So there remains a large part of the market that's still unable to access housing. But you know, as we move further and further into this easing cycle, that should get a bit easier for those home shoppers to get a seat at the table.

Makes sense, Doug. Let's move on to the asset-backed securities market or the ABS market. There are various segments of this market. From your perspective, which areas of the ABS market will be most impacted by this rate reduction process and in what ways?

Well, the most obvious impact to the consumer is going to be on the cost of debt. From credit cards to direct consumer debt to autos, and really everything in between, lower rates mean lower financing costs. The lower cost of financing is going to be beneficial to everyone. Obviously, lower rates mean lower expenses for businesses, which allows for more money to put money back into those businesses by hiring workers, paying workers more and eventually lower prices. So, these lower rates within the ABS market — so, whether you're talking consumer small business — it should help almost everyone in being able to navigate through this economy.

From an investment standpoint, it's a little different. The longer-term implication will be lower rates working their way through to various products that are securitized or exposed to the consumer. So, think car loans or credit cards. As rates come down, the yield that these securities will…eventually they'll move in a similar direction, coming down, though most likely not at the same pace.

What I mean by all of this is that if I go out and buy an asset-backed security that's backed by consumer loans, and I'm getting paid, let's say 10% for the deal that I'm buying, because the underlying consumer is paying a higher rate. The next time there's a securitization with consumer loans, if the consumer loans are charging a lower rate, that means that is going to pay me less. So now I'm going to go out and I'm buying, basically, let's say the same consumer ABS, but instead of earning 10%, I'm going to earn 8%.

And so that's something that we have to take into consideration when we look at our strategies, when we look at the market. We get the benefit of yields coming down, pricing going up on things that are already out there. And so, we'll get that price appreciation on securities we hold. But new securities are going to be coming out at those lower rates. So, there's a trade-off there.

But if you think about it, if I own a security that's paying 8% and the going rate in the market for a new security of the same type is 6%. My 8% security is going to go up in value because I'm earning 8%. Where if I go on the market right now, I'm earning 6%. So, there's that benefit that I'll be getting. It's just the reinvestment is going to be less. And so, it's the reverse, as you would imagine, of what we saw in 2022. As deals were paying down, we were able to reinvest at higher rates because rates were going up. Now we're going to be reinvesting at lower rates because rates are coming down.

Okay. Well, Doug, you mentioned, obviously, there are still could be extraneous events going on. Uncertainty remains in the marketplace, and certainly, a relatively tough job for the Fed continues in terms of not letting the economy fall into recession. What should investors be focused on as we head into the remaining months of 2024?

Well, it feels like now we have clarity with what direction the Fed is going. Now again, as I mentioned, there's a little bit of disagreement between what the Fed is saying and what the market wants. But we know that this easing cycle has started. I don't envision that we're going to see another 50-basis point cut unless we see economic data that would encourage that. But risks still remain. And it's that dislocation between the Fed and the markets on the pace of easing. But you also have, and we've talked about this before, you've got the upcoming November election and now that the Fed has started the easing cycle, they provided us with that insight. I think concerns are going to shift more to the political environment that we're in. And that covers not just the United States, but globally. I mean, you still have the war in Russia and Ukraine. The Middle East continues to ramp up tensions, whether it's beepers blowing up, or walkie-talkies blowing up, or air strikes, whatever it may be. Feels like it just continues to roll downhill and gain more momentum.

But I think right now the election but just as important. And this, maybe, isn't getting as much run in the news. But we've got the potential for a government shutdown if a deal isn't reached by September 30th. So that's less than two weeks away. Now, I think that even if a shutdown were to occur it's most likely going to be limited in both the impact that it has and the time that it takes. But it's another reason for the credit rating agencies to look at US ratings, potentially create some market angst and uncertainty depending on what they do.

But expectations are for yet another short-term deal to be reached, so we can kick the can down the road, keep things running until we get to mid-December, and then we're gonna have to kick the can down the road again.

But what's most interesting could be the impact of a government shutdown on the election. Because Republicans will blame Democrats. Democrats will blame Republicans. And unfortunately, it's sad to think of it this way. But who can capitalize on something like a government shutdown to push their agenda forward? So, I think that's going to be maybe a bigger issue than we're expecting. Not just the shutdown itself or whether it happens but how it can impact the overall election.

And then, of course, any and all economic data that can provide some insight into how the Fed's going to react going forward is going to be key. Our next meeting, as I mentioned, is November 7th. So, we've got a month and a half of economic data. We're going to have two nonfarm payroll reports. I believe two inflation updates. So, we're going to have a lot more information for the Fed to act on. So maybe it can range anywhere from we're going to do another 50 basis points based on what we're seeing. We're not going to do anything based on what we're seeing. So, I think, as more economic data comes out, as we hear more from the Fed and different speeches, it's going to give us an idea of where we're headed. It's just in the interim there might be some volatility that's attached to a lot of those headlines that pop up.

Sure. Well, and, as we often say, Doug, with volatility comes opportunity. So, looking ahead in that vein, what opportunities do you and the fixed income team here at Diamond Hill, what are you guys seeing in the current environment and going forward?

Well, we see more of the same, if you will, and what I mean by that is in the securitized space, we're still seeing better relative value than we're seeing on the corporate side. And this goes along with, you know what we saw in early August. We saw, and we talked about it last time, all this volatility that was very short-lived but very powerful and really hit more corporate spreads than securitized because securitized tends to react in a delay, and by the time it would react, everything had been somewhat resolved. But we saw corporate spreads widen out. They've since come back in. So corporate spreads are sub-100 since the turn of the century. They've averaged somewhere around 145 OAS. So, from a spread standpoint, still incredibly tight.

But we look at CMBS, commercial mortgages, ABS, residential mortgages. They're all still trading at attractive levels relative to corporates. They're yielding more than we're seeing on the Treasury side. So, from an opportunity standpoint, for us, it's looking at parts of the market where we can really dig in and understand the structure, the collateral, the underwriters, and we can find those opportunities to add to the portfolio relative to looking at Treasuries or credit.

Those opportunities that we find are, pardon the pun, but the diamond in the rough where we're finding these opportunities that can add value to the portfolio without necessarily ramping up the risk profile. That's what we're trying to do: to put together a portfolio that we think will do well in a variety of environments. I think some of the backup that we've seen in the Treasury curve provides us a chance to maybe add a little duration in a Core strategy, where we've been a little bit shorter than the benchmark because of what we thought was going to happen with rates.

So, every day is a different opportunity. What is not that attractive today, depending on what happens in the news, could be attractive tomorrow or next week. It's kind of keeping your head on a swivel and looking for those opportunities as they arise.

Okay, well Doug, those are all the questions I have for you today. Any final thoughts for our listeners before we sign off?

I think we should all be happy, I guess, that we've got clarity that the easing cycle has started. As I said in the beginning, this was a really interesting meeting because this is the first time that I can recall, since before the financial crisis, we really didn't know what the Fed was going to do. I think if you looked on Bloomberg and looked at that survey, you probably had maybe 60-40 tilted 50-25 basis point reduction, but there was really no consensus.

So, I think it's a really interesting time. You have to be aware of what you own, where the risks are in your portfolio — and I'm talking fixed, equity, alternatives, whatever it may be — because we just don't know. We know that at some point, corporate spreads, both high yield and investment grade, are going to widen out, but at what level, with what velocity, and for what reason?

The final thoughts would be to make sure, as an investor, you understand what you have, where the risks exist, and that you've got a good handle on those.

Okay, well, thank you, Doug, again for joining us today. Before we go, I will mention one of our upcoming events on October 17th at 2 PM Eastern Time. Doug will be hosting a live podcast with our assistant portfolio manager, Charlie Minor, on the fixed income side, and they will do a deep dive into the asset-backed securities market. So, check out our website for registration details. Those will be live soon if they aren't already available. And Doug and I then will be back for another podcast in November. Doug, again, thanks so much for joining us, always great chatting with you.

Thanks, Jess. I enjoyed it. Great questions, and the conversation with Charlie in October should be great.

We look forward to it. For our audience, for any more insights and Doug's latest fixed income commentary, which is coming out soon, please visit our website at www.diamond-hill.com. Until next time, take care.