by Neil Azous, Chief Investment Officer
Summary
- Taking Stock
- Eurodollars – The End of the Cutting Cycle Observed
- The Next Seven Months
- Multi-Asset Framework Supports What is Being Priced into the Yield Curve
- Asset Allocation – What Does This Mean For Your Portfolio?
Taking Stock
In our September 5, 2018, post “Yield Curve Inversion – What Does It Mean For Your Portfolio Right Now,” we said the Federal Reserve’s (the “Fed”) last interest rate hike for the cycle would be in December 2018.
To support those conclusions, we provided our framework for the different phases of yield curve inversion in the US fixed income markets, and what those historically indicated would happen in the future regarding interest rate policy.
The roadmap we laid out advocated that the Fed would start cutting interest rates as soon as the summer of 2019.
In our February 19, 2019, post “The New Narrative For Lower Interest Rates,” we double-downed on that view, reiterating that the US fixed income market continued to communicate that the Fed will likely be cutting interest rates by the end of the summer or nine months following the last hike.
Fast forward to today and the US fixed income market is providing another key signal – when the cutting cycle will start (i.e., next three months) and end (i.e., Q4 2020-Q1 2021).
We are pleased to see our steadfast view move closer to fruition.
Eurodollars – The End of the Cutting Cycle Observed
The Eurodollar market provides the most real-time fixed income insight of all instruments.
Yesterday, the slope of 16 Eurodollar curves made new 52-week lows, while seven made new highs. On the table to the right, the cells highlighted in red are the new lows whereas those in green are the new highs.
The key signal is how the yield curve inversions that are getting deeper are bunched together at the front of the Eurodollar strip, while yield curve steepening is stacked at the back.
This is the picture of our view being crystallized!
Investors have increased the amount of Fed interest rate cuts this summer and next year, and are betting on an end to the easing in late 2020 or early 2021 before the interest rate cuts have even commenced. This is a seminal event that signals the first rate cut will be “realized” within the next 1 to 2 months.
Note, the “bets” for the end of the easing cycle are not arbitrary but instead based on history – easing cycles tend to last 18 months or less on average. Once the Fed gets to the “zero-bound” by the end of that 18 month period, it is much more likely the next move is a hike rather than cutting rates below zero.
The Next Seven Months
Looking forward to December 2019, the US Treasury market is currently priced for the Fed to cut interest rates one to two times in 25-basis point increments.
We believe the bond market is underpricing the cutting cycle. For example, regarding how much the Fed will cut interest rates, it is no longer about “if” the Fed cuts, it is about “how many” times they cut and “how fast.”
History provides evidence those “cuts” will be as much as 75 basis points or more. While it is common practice for the Fed to raise interest rates by 25 basis points at a time, it is equally as rare for them to cut by 25 basis points at a time.
Therefore, it is probable that the first interest rate cut could be 50 basis points, or 25 basis point cuts could happen in rapid succession. For example, the Fed could cut interest rates by a total of 150-200 basis at four meetings in a row. The difference between the hiking cycle and now is with a press conference at every FOMC meeting, not just quarterly when forward guidance existed, is that the 150-200 bps of cuts could also occur in a short-time span – i.e., six to 12 months.
Also, it is prudent to model increased probabilities for an inter-meeting interest rate cut in case there is an exogenous shock. For example, in all easing cycles going back to 1980, the Fed cut interest rates in between meetings in response to surprise market turmoil or even individual economic reports – Global Financial Crisis (GFC), Dot.com blow-up, Long-Term Capital Management, Russia Crisis, etc.
Multi-Asset Framework Supports What is Being Priced into the Yield Curve
In the first quarter of this year, the three main themes that propelled US equities to new highs were:
1. Lower US real interest rates;
2. End of a trade war with China;
3. Central banks shifting to a dovish policy spurred “green shoots,” which in turn led to a consensus view that growth would trough in the first quarter.
Presently, the only pillar still standing is lower US real interest rates.
We will leave the trade war analysis to the geopolitical gurus but just say this:
“Ten years from now, finance students will look back and view the trade war as an exogenous shock that forced the Fed’s hand to cut interest rates. Ultimately, the trade war will be grouped into the one-off category of Global Financial Crisis, Dot.com blow-up, Long-Term Capital Management, Russia Crisis, etc. This summer will mark one year since tariffs were implemented. However, regarding sentiment, the trade war has been in the market for over 16 months. Said differently, the exogenous shock is already upon the global economy and becoming more embedded in the market by the day.”
By early May, through our data partner ClearMacro, we received numerous signals that the consensus fundamental view – global economic data would trough in the first quarter – was misguided.
Because risk appetite is driven by different factors over various investment horizons, it is important to monitor a short-term risk appetite matrix that projects the appetite to “take on” risk over the next six months and a medium-term matrix that does the same, but over the next 6-12+ months.
Specifically, these matrices measure the positive/negative alignment of hundreds of signals that are likely to influence equity returns over these two holding periods that are then translated into a risk appetite rating designed to guide a portfolio tilt decision. There are seven rating levels, ranging from three red squares (“aggressively risk off”) to three green squares (“aggressively risk on”).
Yesterday, the aggregate of the three key ratings – Economic Activity, Monetary Policy, and Technical outlooks – turned to two red squares or “risk off” for the first time this year.
Asset Allocation – What Does This Mean For Your Portfolio?
We believe it is prudent for investors to hold less risky credit and equity strategies for this environment.
The bulk of credit spread widening in a cycle happens from the point when the Fed finishes raising interest rates until it is deep into a rate-cutting cycle. Why? Because that is when growth expectations are typically rolling over, and recession risks are rising fastest.
Conversely, it is responsible for investors to overweight income-oriented assets in a falling interest rate environment because they can potentially generate excess principal returns.
With the Fed now expected to enter an easing campaign, we advocate holding assets that are the first derivative of looser policy and lower interest rates. Specifically, a defensive strategy of municipal and mortgage bonds is warranted.
Within that defensive strategy, we believe that investors should focus on investing in income-oriented closed-end fund (“CEF”) strategies because as CEF leverage costs decline, their distribution rates will increase, and this will cause their discounts to narrow substantially. Currently, defensive fixed income CEF’s discounts-to-their-net asset values remain in the bottom historical decile. So, the potential discount tightening is very large. Also, the moderate amount of leverage they use can potentially increase principal returns as interest rates decline.
You only get the opportunity once every nine years to take advantage of a Federal Reserve easing cycle by investing in levered vehicles that will disproportionately benefit from lower leverage costs.
This is one of those opportunities.
At Rareview Capital, we are positioned for such an evolution over the next 12 to 24 months.
If you are interested in learning more about how we use our Federal Reserve model to take advantage of lower interest rates in a portfolio or make asset allocation decisions, please call us at 203-539-6067 or email us at info@rareviewcapital.com.
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