Investors should look to embrace high-quality duration as core bonds have historically performed well near the end of a Fed tightening cycle and subsequent reduction in policy rates.

At its June meeting, the Federal Open Market Committee (FOMC) voted to leave the Federal funds rate unchanged at a target range of 5.00%-5.25%. However, refreshed interest rate projections via the “dot” plot suggest this is simply a mid-year skip, rather than a prolonged pause. In fact, the median committee member now anticipates two more rate increases are likely before year-end followed by rate cuts beginning some time in 2024. Given changes in monetary policy are among the most important drivers of stock and bond returns – as evidenced by the year-to-date movement in interest rates and equity market valuations – an important question for investors over the balance of the year is how hawkish the committee might remain given inflation is slowing, yet still running above target.

Exhibit 1 shows the evolution of the expected fed funds rate at the December 2023 meeting since the start of the year. Notably, the June FOMC meeting made it clear that the committee still needs more compelling evidence that inflation is under control and could very well tighten at least once more this summer. As a result, recent market action has removed most of the cuts priced in the second half of 2023 and expected year-end policy rates are near where they were prior to the collapse of Silicon Valley Bank in early March.

At the current juncture, while forward looking indicators suggest year-over-year inflation will continue to decelerate and the U.S. economy could experience, at best, a slowdown or, at worst, an outright recession over the next few quarters supportive of a pause, the committee is biased to tighten further.

Looking ahead, while the Fed has acknowledged there may need to be some pain in the real economy to return inflation to 2%, stresses emanating from the banking sector may force the Fed’s hand to cut rates sooner than it expects as tighter lending conditions act as a drag on businesses and consumers. Roughly 52% of the private workforce is employed by companies with 500 or fewer workers. Many businesses of this size bank at local and regional financial institutions. Given the availability of loans has become more restrictive and securing a loan has become more costly, when businesses look to access credit, it is likely they will be met with a painful reality of having to lay off staff and/or struggle to rebuild inventory.

As shown in Exhibit 2, tighter credit conditions tend to lead weakness in labor markets. Moreover, banks may still be pressured by deposit outflows given more attractive rates elsewhere; unrealized losses on bond holdings given higher rates and potential write-downs on commercial real estate holdings could continue to pressure lending capacity.

Investment implications

  • Even though Fed commentary remains hawkish, the backdrop of slowing growth and falling inflation should bias long-term yields lower through the end of the year. 
  • While we don’t expect a collapse in the banking system, we recognize that stresses on regional banks are unlikely to subside until the Fed starts cutting rates. Moreover, tighter lending conditions are likely to contribute to labor market weakness, a rise in default activity and slowing private fixed investment.
  •  Investors should look to embrace high-quality duration as core bonds have historically performed well near the end of a Fed tightening cycle and subsequent reduction in policy rates.
  • As the Fed potentially shifts its rhetoric in favor of lowering rates later this year, while supportive of higher equity multiples, it will likely be in response to economic weakness, a poor environment for risk assets, especially growth equities. Therefore, we continue to lean into high-quality companies with strong cash flows in portfolios.