Will the First Cut Be the Deepest?

George Bory: I'm George Bory, chief fixed income strategist for Allspring Fixed Income, and welcome to SpringTalk. Earlier today, September 18, in a historic moment for the Fed (Federal Reserve), they cut the Fed Funds Rate by 50 basis points and signaled to the market that they expect to continue cutting rates over the next 12 to 18 months. I think this is best categorized as a “recalibration of policy stance,” which is what Chairman Powell said in his press conference. Equity prices dropped and longer term interest rates rose after the announcement. So, what gives? Why did they do this? And what should we do about it? Well, despite achieving the proverbial soft landing of raising interest rates without causing a recession, the Fed still needs to navigate ongoing inflation uncertainty and questions regarding the health of the labor market. In the Fed's survey of economic projections, they signaled that the pace of cuts that are likely to come are likely to be slower than what the market is pricing in. So, while the Fed expects to cut rates, the market seems to have wanted more and still wants more. Secondly, growth is expected to slow, according to the Fed, and, in fact, slow to below trend from what is currently above trend growth. And then, finally, inflation. Inflation has been the challenge for the Fed for the last couple of years. And their forecast suggests that inflation should come down. But it is still going to be an extended and long drawn-out process. So, there seems to be a bit of a disconnect between what the Fed is doing and what the market expects. And so, what you saw in the markets is really a classic case of buy the rumor and sell the fact. Now, for investors, bond investors, in particular, the question is what should we do? And we've had a long standing recommendation at Allspring that bond investors should diversify their duration. And that is as much true today as it was at the beginning of the year and is likely to continue to remain a central strategy for us and a recommended strategy for you, our clients. And what does that mean? It means we should position ourselves along the curve strategically. That one-directional bets—rates up, rates down—is not necessarily the highest-quality decision. We like duration in say, the two, three, four, five, even six and seven year parts of the curve. In the intermediate part of the curve, duration still looks reasonably attractive. But more importantly, we have expected and continue to expect the yield curve to steepen even from levels that we saw today and are likely to see going forward. Secondly, credit spreads have been quite tight, but with the Fed cutting rates, that should be a boost to the economy. That should help risk assets despite today's sell-off. So, it may take some time, but we do expect credit spreads to remain fairly tight. Now, thirdly, the dollar. The dollar has been very strong for a very long period of time. That started to crack earlier this year, midsummer, when the Fed started to talk about rate cuts. Now that rate cuts are underway, we are seeing the dollar starting to weaken. And that is something that we think will continue going forward. And then just lastly, as it relates to the tax-exempt part of the U.S. market, the municipal bond market, no great surprise, munis are tracking Treasuries very closely. But munis continue to outperform the Treasury market, something we expect to continue over the course of this year and into next. So, as we think about our strategy as we go into the end of the year, we see a favorable macro backdrop, one where the Fed is moving to lower rates. That should help stabilize yields and, ultimately, bring yields down, but curve positioning will be critical. Credit selection will be top of the list for investors, whether you're in a taxable portfolio, tax-exempt, domestic, or international. And lastly, for bond investors of all stripes, preserving flexibility in your portfolio is critical. Be nimble. Be quick. I'm George Bory, chief investment strategist for the fixed income group at Allspring, and thank you for joining SpringTalk.

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