Trading Desk Talk

Top Line

• Is Powell to blame?

Is Powell to blame? — Treasury rates have surged recently, as market participants reset interest rate expectations. At the start of 2024, investors were expecting 100 to 150 basis points (bps) of rate cuts from the Federal Open Market Committee (FOMC). This expectation was based on the view that inflation would continue to trend lower, finally getting back to 2% for the first time since March 2021.

Instead, inflation has exceeded expectations every month in 2024 and the annualized pace of the Consumer Price Index (CPI) remains firmly above 3%; stronger-than-expected job growth and consumer spending in March added fuel to America’s inflationary fire. Rate-cut expectations have fallen dramatically as a result and investors now expect only about 40 bps of cuts in 2024. Meanwhile, the yield on the 10-year Treasury note increased—from 4.20% at the end of March to a recent peak of 4.69% on April 16, before closing last week at 4.62%.

There is plenty of blame to go around for the country’s stubborn inflation. A persistent shortage of housing is one cause, as are rising medical costs, commodity prices, and insurance premiums. Some economists and strategists also point the finger at Federal Reserve (Fed) Chair Jerome Powell for prematurely telegraphing interest-rate cuts, which, in turn, kindled unmerited optimism in financial markets. Powell has said repeatedly over the last year that inflation will slowly shift lower as the lagged effects of restrictive monetary policy take hold on key segments of the economy, such as housing, which makes up the highest share of the CPI (about 33%), as well as the second-highest share (about 16%) of the Personal Consumption Expenditures (PCE) price index.

Following the December FOMC meeting, Powell said the federal funds rate was “well into restrictive territory” and made clear that the Fed had shifted its focus from rate hikes to cuts. “There’s a general expectation that this [rate cuts] will be a topic for us looking ahead,” declared Powell. His statements helped pushed the yield on the 10-year Treasury note down by about 30 bps that same week. His statements also reinforced a rates’ rally that began in early October and that ended 2023 with a 3.88% yield on 10-year notes. “They [the Fed] just got the inflation picture wrong [in recent months],” lamented Stephen Stanley, chief US economist at Santander US Capital Markets. “The mistake they made was they got really enamored with the combination of really strong growth and benign inflation that we saw in the second half of last year.”

As for the possibility of a rate cut in 2024, the Fed may be running out of time. That’s because in the second half of this year, the annualized 2024 inflation figures will be compared to late 2023, when price pressures were dropping rapidly. Michael Gapen, head of US economics at Bank of America, summarized the math. “Essentially, whatever the year-on-year inflation is by June is likely to be around that level at the end of the year. If you don’t move in June, [the first cut] could move from June [2024] to next March [2025].”

There is also the issue of the timing of cuts in relation to the November elections. The Fed has always maintained that it is an apolitical institution; Powell has reiterated that stance many times over the past few months. However, the closer to November that any cuts are made, the more the Fed will likely be criticized by Trump and many Republicans for boosting Biden’s re-election efforts. “One of Chair Powell’s responsibilities is to protect the public standing of the Fed,” said Vincent Reinhart, chief economist at Dreyfus and Mellon and a former top Fed official. “The closer the FOMC acts to the election, the more likely it is that the public will question the Fed’s intent, undermining its democratic legitimacy.”

In addition, there is the issue of rate cuts in relation to what other countries are doing. The rate-cut path currently looks smoother and shorter for other major central banks because the economies they oversee are not growing as fast as the U.S. (and some may not be growing at all). We will see first quarter U.S. GDP growth on Thursday, April 25. A Bloomberg survey suggests a median forecast of 2.3% GDP growth, quarter-over-quarter (QoQ), while the Federal Reserve Banks of Atlanta’s GDPNow forecast is for 2.9% growth (U.S. unemployment was 3.8% in March).

The Eurozone’s GDP is barely above water at 0.2% and its unemployment rate is around 6.5%. European Central Bank President Christine Lagarde has been telegraphing summer rate cuts for two months. “If we don’t have a major shock in developments, we are heading towards a moment where we have to moderate the restrictive monetary policy that we have,” said Lagarde last week.

Elsewhere, the Bank of England is likely to begin cutting rates this summer too. The U.K.’s GDP growth is around 0.2%, QoQ; the country’s unemployment rate is pushing past 4%. The Fed’s northern neighbor, the Bank of Canada, has been one step ahead of Powell & Co. since the beginning of this cycle. Canada’s QoQ GDP growth is about 1.0% and its unemployment rate is pushing 6%.

To be sure, none of these countries have achieved the 2% inflation goal (the Eurozone is the closest, at 2.6%). Yet all three are now expected to be in position to cut rates before the Fed. If the FOMC shows the patience that it has been preaching—and launches cuts in late 2024 or early 2025—the Fed will likely be criticized heavily for managing rate-setting less adeptly than the central banks of some of our allies. This sales and trading desk, however, will not be among the critics: We’re rooting for the Fed to stay the course. We believe that a premature rate cut, followed by a hasty reversal, would destroy the Fed’s remaining credibility. Yes, the Fed got a late start hiking rates in 2021. But much of the inflationary pressure came from massive deficit spending by the U.S. government—before, during, and after the pandemic. In our view, more of the blame for stubborn inflation goes to the federal government than to the Federal Reserve.

From the Desk

Agency CMBS — A flood of bonds out for bid in the secondary market last week came as a surprise, as investors looked to unload almost $3 billion of Fannie Mae and Freddie Mac bonds mid-week. The supply caused Fannie spreads to increase up to five bps, week-over-week (WoW). Much of the selling was viewed simply as profit-taking, after spreads on agency commercial mortgage-backed security (CMBS) paper generally contracted for the prior four to five months, outperforming most other fixed income sectors.

The spread widening came despite relatively low new-issue volume and was more pronounced for new-issue bonds of less than $8 million, as well as for off-the-run structures, such as wide window prepays, DPPs, credit facilities, MHP/seniors/student projects and supplementals. Ginnie Mae spreads held up better, increasing by about two bps, WoW. Some Federal Housing Administration loan borrowers must have capitulated to the Treasury selloff by the end of last week—we saw over $100 million of new-issue Ginnies come to market Wednesday to Friday.

Municipals — AAA tax-exempt yields were higher across the yield curve, WoW. The AAA tax-exempt-to-taxable ratio remained steady, WoW (five-year and 10-year ratios sit at 59%). In the affordable housing sector, we continue to see spreads tighten on primary new-issuance transactions. Fannie-enhanced Mortgage Tax-Exempt Bonds (MTEBs) were priced at a negative spread to the 10-year Treasury this past week. That spread was +9 to +14 bps to the 10-year Treasury just one week prior.

Municipal bond funds saw a large outflow totaling $1.5 billion last week. The high yield fund component fared better than the overall sector, losing only $48 million. This development marked the first weekly outflow from high yields funds since the opening week of 2024.

Economic Calendar for the Week Ahead

Summary of Global Fixed-Income Markets

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