‘the Fed should start cutting rates’

Good morning. Forecasters see the US economy adding 170,000 jobs in December with the unemployment rate nudging up to 3.8 per cent. Just yesterday, though, two labour market measures (ADP payrolls and jobless claims) showed surprising strength. A blowout jobs day wouldn’t be entirely shocking. Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

Friday Interview: Bob Michele

When trying to solve bond market mysteries, Unhedged has long depended on the wisdom of Bob Michele. He is co-chief investment officer of JPMorgan Asset Management and leads JPAM’s fixed-income business, with final responsibility for both operations and investment performance. He talks below about where yields are headed, why concerns about fiscal deficits might be overdone — and why the Bank Term Funding Program may have been the Fed’s most important intervention. The interview has been edited for clarity and brevity.

Unhedged: You have written that there is a meaningful chance the Fed completes 10, 25 basis-point rate cuts in 2024. The market consensus is for about six. Can you walk us through your thinking? 

Bob Michele: They’ve only got eight meetings, so you’ve got to do a bunch of 50bp increases in there. But I think they’ve opened the door to that. The pivot at the last meeting was a way for them to say that inflation is pretty much at their target, and if the labour market continues to cool, why not bring down real yields? I agree with them. 

The fed funds rate at 5.5 per cent, plus quantitative tightening — those policies were designed to bring inflation down from high single digit/low double digit levels, and for unemployment, which was closer to 3 per cent. But inflation has come down a lot. One of the things we like to look at is the six-month annualised rate of core personal consumption expenditure inflation. On that measure, we’re at 1.9 per cent, below the Fed’s 2 per cent target. Two or three years ago, it was at 6.6 per cent. And as inflation has come down, the real fed funds rate has gone up. So even though the Fed hasn’t hiked rates since July, policy has become tighter. The Fed has a lot of capacity to bring rates down here. 

If they cut by 250bp, that brings the fed funds rate down to 2.75-3 per cent. They have told us that the neutral rate is about 2.5 per cent. If so, that means a real fed funds rate of about half a per cent. So even that is just getting down towards what they consider to be neutral today.

Unhedged: At the same time, though, you have flagged that the biggest risk is a hotter than expected economy and a resurgence in inflation.

Michele: I tip my hat to the Fed. They have engineered a soft landing. You’re pretty much bang on the 2 per cent inflation target. You’ve got unemployment at 4 per cent or below for 24 consecutive months. They’ve met their dual mandate of full employment and price stability. I just think soft landings are notoriously difficult to maintain, and their best hope of ensuring that we stay in a soft landing is if they gradually start bringing down the fed funds rate; otherwise real rates will be too powerful a headwind. And if they bring rates down too rapidly or end QT too quickly, you run the risk that things accelerate again. To us, those look like roughly equal probabilities.

Looking at these tail risks, higher inflation is the one that is more problematic for markets. Businesses and households just absorb the high- rate environment, and suddenly you see home sales start to pick up again, auto sales pick up and businesses invest, and that creates a higher level of inflation. Then the Fed not only has to stop cutting rates, they have to consider hiking rates again, the discount rate on every class has to go back up again, and prices fall. 

Unhedged: Does a 250bp-cut scenario require changes in the data, such as a clearly rising unemployment rate? Or is more of the same enough?

Michele: For us, a soft landing looks like inflation stable around 2 per cent on a three and six month run rate and unemployment at around 4 per cent. That kind of stable environment is when the Fed has scope to continuously bring rates down. 

Unhedged: Turning to the long end of the curve, with the 10-year Treasury yield at 4 per cent, do you think there is anything left in the duration trade? 

Michele: There is room for the two-year to come down the most, towards where you would see the terminal fed funds rate, about 2.75 per cent. And then you’d expect the 10-year part of the curve to be somewhere around 3.5 per cent, maybe a little bit lower. [In that scenario] there is a positive term premium and the front end approximates the fed funds rate. It just feels to me if we’re wrong on that, it’s not that rates will be higher, but that rates will be lower.

It’s funny, you started this conversation saying this looks like the year for fixed income. But we could have had this conversation in January of last year, when “bonds were back”. What happened to that? We ended the year at exactly the same level on the 10 -ear and with the two-year just a bit higher. What happened is the Fed kept hiking rates into July and investors realised if they just put money in money market funds, they could get a 5 per cent or 6 per cent yield pretty easily. Despite that, money still came into bond funds and bonds did reasonably well.

What happens now? If you’re in a year where the Fed starts cutting rates, yields on money market funds come down and cash starts pouring into things like fixed income because this year it’s real. I think we have just below $6tn in money market funds; it’s up $1tn in 2023. And you go back another few years, it has almost doubled. That money could come into the market and chase yields lower than even where theory tells you it could.

Unhedged: What is their logical next step for investors? Moving to the middle of the yield curve?  

Michele: Money is certainly going to go into general bond funds. So investment-grade securities will do well. And high taxpayers will put it into general municipal bond funds. Professional investors will look at everything and weigh credit versus government bonds and agency mortgages versus high yield and emerging markets. Right now, those look pretty cheap in a soft landing environment. Not perfectly cheap, but if we’re in a soft landing and default rates remain low, then credit spreads on high yield could go through 300bp [down from 370bp today]. 

Unhedged: Does the logic you just laid out hold for the riskier ends of the credit spectrum, such as in triple-C high-yield bonds or leveraged loans? Do you get paid enough at current spreads to take on that much credit risk? 

Michele: That’s a really good question because it’s been bifurcated. Nine months ago, we had a regional banking crisis and it looked as though central bank tightening was starting to bite hard. Everyone, including us, assumed at some point in 2023 we would tip into recession. The debate was how deep a recession it would be. So money that did go into high yield went into higher quality, including double-B bonds. 

Although default rates have gone up a bit in triple-C bonds, in bank loans and in private credit, the reality is they’re still low in historical terms, and there’s still a tremendous amount of dry powder available, particularly in private credit, looking to go in and provide support and restructuring. So if we do stay in this soft landing environment, yes, triple-C credit spreads and bank loans will do well. And I will tell you that just recently we added to both of those in our portfolios. 

Unhedged: Do worries about the US fiscal situation have a place in constructing a portfolio?

Michele: I started in the business in 1981, in the era of twin deficits [a fiscal shortfall combined with a trade deficit, ie, imports exceeding exports]. I was told the US would never be able to balance its budget again, and that the US should never be allowed to fund itself below 10 per cent yields again. And of course yields promptly went from close to 16 per cent down to 1.5 per cent over the next 27-odd years. And during the Clinton administration, we more or less got a balanced budget. 

So I caution against thinking too much in the near term. We have to step back. We had a pandemic and got the policy response we wanted and needed, which was unlimited fiscal and monetary support. We’re still in the Covid shadow. The Fed is trying to drain some of that liquidity away, and you are seeing more discussions on the fiscal side about how we bring down the deficit with debt-to-GDP looking too high. 

The next phase I think we go through is, once we fully emerge from the Covid shadow, a period of sustained growth. It could look like it did pre-financial crisis, because of demographics. The 1991 births are the largest population cohort for any single year; they will all earn, spend and save. Just like we saw during the Clinton administration, there will be plenty of growth to generate tax revenue and stabilise the federal deficit and government spending. 

Importantly, too, we can look at Japan over the last 30 years and ask, at what point does debt-to-GDP not matter? They’ve had debt-to-GDP in the hundreds of per cents for a long period of time, yet have managed to keep things ticking along. Of course, you would like the government to apply more fiscal discipline going forward. But you are seeing a lot more conversation on fiscal discipline coming from Washington. So I’m not that concerned.

And I don’t want that to muddy the message that we’re about to see the Fed cut rates. That’s always good for buyers. You always get a bond bull market; don’t miss out on yields here. I think more bad decisions get made in the bond market on supply-demand [dynamics] than anything else I’ve seen. People always, always worry too much about supply, and where demand will come from. 

Unhedged: Speaking of Japan, should we own yen? JGBs? The Japanese stock market and economy surprised people positively last year. What’s your view?

Michele: We did put yen as one of our five surprise projections for 2024, and we do own yen versus dollars in our portfolios. Many clients think we’re crazy. But all we’re doing is taking [the yen-to-dollar exchange rate] back to where it was before the Fed started hiking rates. If you go back to the period between 2019 and 2021, yen traded around 105 to 110 [yen per dollar] for a long period of time. It only knifed higher when the Fed started hiking rates in 2022, when you went from 110 to 152 by October 2022. That’s pretty much the teeth of Fed rate hikes. So if we’re right that just the Fed starts to bring down rates 250bp, you should see a lot of that reverse. And if the once-unthinkable happens that the Bank of Japan starts hiking rates, which appears to us they’re setting the market up to do, likely after their fiscal year changes in March, now you’ve got two powerful tailwinds for yen. 

Unhedged: Looking back over the period between when inflation first picked up in 2021 through the end of 2023, what calls did you get right and what did you get wrong?

Michele: We’ve generally been pretty good. We were calling for the Fed to hike rates meaningfully at the end of 2021 going into 2022 and a meaningful bond bear market. We got a lot of that. Then coming into 2023, we said growth and inflation are just too high; given how far all central banks have hiked rates and the amount of quantitative tightening that’s going on, growth and inflation are going to come down continuously through 2023 and we should be concerned about recession. We did get the decline in growth and inflation. Ultimately, it was good for bond prices. We thought it would be good for high-quality credit. So we got all of that. 

I would say our biggest miss is we thought that the US economy would be in recession and high-yield credit spreads would reprice wider for that. And neither of those things happened. 

We went back and tried to figure out how did we miss that, what happened? We go back to the policy response to the regional banking crisis. And it appears to us that through the end of March, we were right. The amount of rate hikes and quantitative tightening were creating fractures in the system, specifically in the regional banking system, and we were headed to a fairly meaningful recession. But then you look at the policy response from the Fed and the Treasury, and it now, in retrospect, looks to us that the Bank Term Funding Program was the equivalent of a 200bp rate cut targeted to the banking system.

The problem back in March was that a lot of the regional banks were seeing deposit outflows as customers took cash out to pay for things [amid rising prices] or they were moving cash into money market funds. As their deposit balances went down, they had to start liquidating their securities portfolios to meet deposit outflows, and their securities portfolios were at about $0.90 on the dollar. So of course when you start liquidating securities at $0.90 on the dollar, you become insolvent.

That’s why the Fed and the Treasury stepped in with the BTFP, taking securities at $0.90 on the dollar and exchanging them for 100 cents on the dollar to meet deposit outflows. If the average duration of the securities portfolio is about five years, that’s the equivalent of a 200bp rate cut. That’s what we missed: how the policy response to the regional banking crisis stabilised the banking system, which allowed a pretty sharp V-shaped recovery. 

Unhedged: That suggests that if you can avoid the crisis, you can avoid the recession. In a tightening cycle, something usually breaks. If you can stop that, you have a much better chance of steering around recession.

Michele: You’re exactly right. Much higher interest rates create a higher cost of funding everything. While slowing things down, it also creates a frailty throughout the system, which exposes you to a shock. We got that shock in the regional banking system, but the policy response came very quickly. 

The one soft landing I’ve lived through is 1995. Remember, the Fed hiked rates over a 12-month period from January 1994 to January 1995, going from 3 per cent to 6 per cent. But then they started cutting rates very quickly thereafter because they saw things slowing down. And I feel that given where rates and quantitative tightening are, we’re in a similar position where we know the broader economy is vulnerable to a shock. We already saw that in the regional banking system. Now that inflation has come down, before the next shock materialises, the Fed should start cutting rates and take away some of that vulnerability.

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