Whether It’s 25 or 50, Rate Cuts Are Coming

Jeffrey Buchbinder:

Hello everyone, and welcome to the latest LPL Market Signals Podcast, Jeff Buchbinder, you host for this week. We're going talk a little bonds and a little Fed with my friend and colleague Lawrence Gillum. How are you today, Lawrence?

Lawrence Gillum:

I'm doing great, Jeff. It's always fun to start the week after a surprising win from your football team. Tampa Bay Bucks two and oh this year. Did not see that coming.

Jeffrey Buchbinder:

This podcast is undefeated because Mike can't say Chiefs won again. So four and oh. How about that? Hopefully we'll be able to say that next time you're on. Maybe in, I don't know, four weeks from now. We'll see. So it is Monday, September 16, 2024 as we are recording this. Here's our agenda for today. Recapping a really good week for markets last week. Actually the stock and bond markets, especially stocks. Then I'm going hand it over to Lawrence to do most of the talking in the middle here. Agenda item two, election implications on the muni bond market, which is the topic of our Weekly Market Commentary this week. Then next course, the big event of the week, the Fed. So we'll preview the Fed meeting. I put in here, "Look Beyond September 18," because while everybody's focused on 25 basis points or 50, we think it's important to think about where they might go from here. Right?

Jeffrey Buchbinder:

How fast might they get to a neutral stance? How many cuts might they do this year and next? So that's the reason for that piece. And then finally preview the week ahead. I mean, it's going be redundant. The week ahead is about central banks, but we do have retail sales, which certainly matter. So we'll preview that as well. So, starting with the market recap, this was a spectacular week for stocks, and frankly, I think it caught some people off guard because we were up a little going into Wednesday, but not much on the week, and then all of a sudden you had Nvidia CEO, Jensen Wong, make a comment at a tech conference about demand being strong and the customers being frustrated that they can't get as many chips as they want, as fast as they want.

Jeffrey Buchbinder:

And the S&P 500 went from a decline of 1.6% to a gain of 1.1% intraday to close up 1.1%. So that was really the key to the week, that reversal. Then we added to gains late in the week on expectations for the Fed to potentially do 50 basis points. You ended up with a perfect week five for five S&P up every single day, up over 4% for the week, very close to an all time high. In fact, about a half a percent or so, a little more than that from the record closing high in July. So just really, really strong. And of course, you know, given Nvidia really drove the turnaround with a little bit of help from the Fed, it makes sense that tech would lead. So we had a very strong week up, 7% plus for tech.

Jeffrey Buchbinder:

And that, of course, leads you to a growth over value week in a big way. You know, everybody's talking about how value is due, and values had good weeks, and we've been talking about that ourselves internally within the LPP Research department. But if you look at the year to date, it's still growth strongly ahead of value 23 to 15 based on the Russell 200 style indexes. International markets just can't keep up. This is the worst possible market for international to keep up because you have a strong U.S. market that is tech led. You just don't have as much tech over there. And then China, you know, China can drive EM if China's down, certainly almost impossible for EM to keep up with a strong U.S. market. So that's indeed what you have, kind of continuing the story of this year. So turning to the bond market, I know Lawrence that, you know, bonds were strong last week. I also know that Treasury auctions were part of that story.

Lawrence Gillum:

Yeah, that's right. So we did have a a decent week last week. Not the type of week that we saw in the equity market, of course, but a positive one nonetheless, up about 50 basis points for the Bloomberg Aggregate Bond Index. Perhaps quietly having a pretty good 12 months, up 10% over the past year, which was good to see after 2022's big loss with kind of recovered a lot of that that drawdown from 2022. But looking at last week in particular, the rally led by mortgage-backed securities and investment grade corporates up about 60 basis points each. The Treasury market, up about 40 basis points. But to your point, Jeff, there were three auctions last week. There was a three-year, a 10-year, and a 30-year auction. Three-year and 10-year auctions were really well received.

Lawrence Gillum:

I've seen, you know, there's a grading scale out there, and I've seen a lot of A pluses for those Treasury auctions. So those were well received. The 30-year, not as well received. I think there's still a disincentive to own long maturity securities at this point, given what's priced in the markets, which we'll talk about in just a second. But nonetheless, yields were lower over the past week, which caused bond prices to move higher across most fixed income markets. Last thing I'll comment, preferreds, up almost a percent last week, up nearly 17% over the past year. Those are equity-like returns from a hybrid fixed income market. So we still think preferreds are a good plus sector allocation. We don't think we're going get 17% over the next 12 months, but given starting yields that are still relatively attractive versus a lot of these other fixed income markets, preferreds, we think, are still in a pretty good spot on a go forward basis. I'll leave munis to our discussion a little bit later, but they were slightly positive but they continued to underperform the taxable alternatives.

Jeffrey Buchbinder:

I wonder if that preferred strength is related to the market's knowledge that financials tend to do well when the Fed starts cutting. What do you think?

Lawrence Gillum:

I think there's some of that as well. And there was some some data that was released, I think it was from the Fed about capital control or capital cushions that weren't as onerous as previously expected. So there were some positive news surrounding some of these larger financial institutions, which are the big issuers of preferred securities. The interest rate environment has or is going to be improved. We're starting to see a more normal looking yield curve, an upward sloping yield curve, opposed to that inverted yield curve that we've seen over the last two years. So it does seem like it's lining up pretty well for financials in general.

Jeffrey Buchbinder:

I also think the high yield, I mean, its gains, but it's a little bit of an underperforming week, I think. That's interesting. You've talked about how high yield's expensive in a week where the equity markets are up four plus percent, you would think high yield would do better.

Lawrence Gillum:

Yeah. What's interesting is that the high yield market has... Valuations aren't really great for the high yield market. But what we did see last week, we saw the triple C rated cohorts outperform the higher rated high yield companies. So it's still no concern or scare out of the high yield market about a recession. We tend to see CCC rated companies, these are the companies that are the lowest rated within that high yield index. The ones that are most prone to default they tend to underperform if there was an economic growth scare. But right now we're, we continue to see stress distressed in these lower rated companies outperform the higher rated cohorts. So it's a pretty interesting dynamic going on in the credit markets, which is completely different from what we're seeing in the rates market, which we'll talk about when we get to the Fed. So it's pretty interesting dynamic in the markets right now.

Jeffrey Buchbinder:

Yeah, certainly bond market's not sending a recession signal. I think we're getting a Fed rate-cutting signal from the commodities markets and the currency markets because the dollar was down over a half percent last week, which is a huge move for any currency. And you're talking about a 4% plus decline in three months for the DXY U.S. dollar index. That's a big move. So clearly the market is anticipating an aggressive Fed rate-cutting cycle, and one that could start with 50. We've still been a little bit on the 25 basis point side, rather than 50, but based on what's happened over the last few days frankly, I wouldn't be surprised if we got 50, but we'll get to that in a moment. So really strongly for commodities. When the dollars weak, you'd expect precious metals to do well, and they sure did. No doubt.

Jeffrey Buchbinder:

Gold prices like Fed rate cuts. So here's a chart of the S&P and then we've got the 10-year yield next. This is kind of a similar spot to where we were a few weeks ago when we were testing that technical resistance, trying to break above the all-time highs around 5,667 on the S&P 500. So we're about 40, 50 points below that. Not much below, that's less than 1%, but we think that it's going be tough to break through that because of this resistance. You've already failed once. And that's just a big number, given what's priced into this market and given how we've sort of held this upward sloping channel for really the whole year. Actually more than a year. That's a tall order. That's a taller. So we're, our bias is that we roll over. Get another pullback.

Jeffrey Buchbinder:

It's hard to say if it's going be five, ten or more, but this is the type of year we know seasonality is weak, September and October. You got the uncertainty around policy with the election. Another assassination attempt on President Trump certainly doesn't help give us clarity on anything. That's an environment where we think at this point makes sense to be a little bit, just a little bit, biased toward the downside. So that's that. Still neutral equities overall, but very watchful of a pullback. So turning to Treasuries, Lawrence, I know we've been pretty steadfast with our forecasts, right? That 375 to four and a quarter are you still sticking with that? And where do you think the downside risk potentially could be if that forecast proves to be incorrect?

Lawrence Gillum:

Yeah, no. I still do have a 375 to 425 target for the 10-year. Coming into the year, we priced in two to three rate cuts, but more importantly, we priced in a steeper yield curve. Right now, the difference between two-years and 10-years is positive finally, but it's only about seven basis points. I still expect that the curve to steepen throughout the course of this year into next year. So I think that we're probably... Given what's priced in the markets and given the economic data that isn't necessarily showing recession imminently, I think that we're kind of at these current levels, maybe a touch higher, over the course of the rest of this year.

Lawrence Gillum:

I know that from a technical perspective, if we break the 360 threshold, that next level is 325. I think if we get to 325 though, that means markets are starting to get really worried about a contraction and not just an economic slowdown. When we look at what's priced in the markets right now, fed funds futures over the next, call it 12 to 16 months, are, I would argue, fully priced in terms of getting the fed funds rate back down to neutral. And so any further pricing of rate cuts would be dependent upon the economy slowing or even contracting more than what we think it's going happen. So I think we're perhaps as close to being done on the 10-year as we can be given the economic data again, unless things, you know, play out worse than what we're expecting.

Jeffrey Buchbinder:

Yeah, the Atlanta Fed GDPNow, trackers' at two and a half. So it looks like, I mean, that can be off a little bit, but it looks like we're going to get another quarter of decent economic growth, and the labor market continues to hold up. Obviously it slowed, but continues to hold up. So pricing in a recession does not seem prudent at this point. And I think you're seeing that in, you know, in the yield curve and in rates kind of holding in this, this range, I guess China's maybe exporting some deflation and, you know, they've just continue to report weak data and, you know, if the Treasury auctions go well, you know, maybe maybe 360 is kind of the new normal. We'll have to see. But totally with you, Lawrence, that there are upward pressures on yields that are going make it very hard for them to move much lower here in the near term.

Jeffrey Buchbinder:

So let's go to munis here. You can promote your Weekly Market Commentary, Lawrence. It's, you know, munis are normally not the most interesting topic in my opinion, but you might even agree with that among all the things in the bond market you could be paying attention to. But I think the munis are really interesting now because of the election. And so, you know, I think it's good for people to think about this rather than just, you know, think about them as sort of static you know, yielding what the published yield is. You really want to think about it in terms of tax equivalent yield. So interested in how you would, you know, walk our listeners through that.

Lawrence Gillum:

Yeah. So first of all, big fan of munis. What's not to like about munis? Remember boring is exciting in the fixed income market. So the more boring the market is, the more exciting it is for me and munis are thankfully pretty boring. There's still high, pretty high credit quality. So the defaults, downgrades are, it's a lot... You know, there are a lot fewer of those in this market versus the taxable market. So I think munis make a lot of sense for those investors that are investing and saving and trying to get good after-tax returns from fixed income. So we wrote about munis this week because of the election twist associated with munis. As we all know, election season is in full swing.

Lawrence Gillum:

And as a reminder, I put this chart in here just to remind everybody that regardless of who wins in November, whether it's Kamala Harris or Donald Trump, it's going be a hard battle to get deficit spending under control. And again, regardless of who's in office, budget deficits are expected to continue to grow to the tune of, call it six to 8% of GDP over the next 30 years. And that's not including any new spending or new tax cuts. So this is likely an understatement. And this data comes from the Congressional Budget Office, the CBO. So this is official government data. So these are not our own forecasts. But the deficit story is likely going be one perhaps throughout our lifetimes unless they can reign in either spending or increase taxes.

Lawrence Gillum:

And that's what makes this chart interesting as it relates to munis because of the tax exempt status of munis. So the hard thing to do right now is to cut spending, given all the mandatory spending, and of course, the interest expense on the debt that continues to grow. So, frankly, there's two ways, two traditional ways to fix this budget deficit; cut spending or raise taxes. Cutting spending may not be realistic given the mandatory spending that's eating up the budget. So it looks like taxes may be going higher, and nobody wants to root for higher taxes, of course, but munis do provide that tax-exempt status, and if taxes continue to go higher that munis will be more attractive. If we go to the next slide to your point, Jeff, the tax equivalent yield is important right now and could get better depending on the outcome of the election.

Lawrence Gillum:

If you look at just the index yield right now, the index, the Bloomberg Municipal Bond Index, is yielding around 3.4%. Given the current tax rates, the tax equivalent yield is around 5.7%. That assumes that the tax rate, top tax rate is closer to the, what is it, the 30, in my notes, to the 35, 36% level. If the Tax Cut in Jobs Acts, the TCJA, if that expires, which it sets to do in 2025, you could have higher marginal tax rates and that would revert back to the 39.6% marginal tax rate before that act was put into law. So if you use the higher tax rates versus the ones we're showing here, you get tax equivalent yields that are closer to 6% than this 5.7% level.

Lawrence Gillum:

So again, no one wants higher taxes, but given the deficit spending, we may be headed that direction, and that makes munis more attractive. Moving on to the next slide. The challenge though, and maybe a potential speed bump for munis is that we're not in a very favorable seasonal period right now for munis. This looks at monthly returns of the Bloomberg Municipal Bond Index, and the, call it, pink color there represents some of the more negative periods. The, you know, deep red is the worst periods, and then you have the traditional red color which is kind of the second to the worst market environment. August, September, October tend to be traditionally weak for munis. And that's because municipalities tend to load up on issuance. There's a lot of supply coming to market over the next couple months.

Lawrence Gillum:

September and October tend to be the biggest supply months for munis for the year. So if that holds we're likely to see a headwind to performance, given the amount of supply coming to market, and just the lack of reinvestment. So, I like munis. I think muni yields are attractive at current levels, and they could be get better depending on who wins the election but over these next couple months, it could be pretty challenging for, for current investors. So I think yields are going, you know, move lower over time. But these next couple months are historically challenging. One thing to comment though is that Fed rate cuts tend to help the muni market as well. So we've got Fed rate cuts, we've got favorable fundamentals, we've got still okay valuations for the muni market broadly and potentially higher taxes. So I think the muni market is the place to be for those longer term investors that are worried about after-tax returns.

Jeffrey Buchbinder:

Lawrence, I think you got me excited about municipal bonds.

Lawrence Gillum:

It's a great story right now.

Jeffrey Buchbinder:

When you've got several positive factors working for you and you got, you know, decent starting yields and you got that tax savings, I mean, remember how long we were dealing with really, really low rates? You know, we're not saying load up your bond portfolios with just munis, but this has been a period where bonds look about as attractive as they looked in a decade. And certainly it makes sense to have munis as part of your your overall allocation.

Lawrence Gillum:

And one of the interesting things is that given the deficit spending and deficit spending as far as the eye can see, one thing that always or has historically come up is, I mean, it's Congress so I don't know how real this is or how worried as investors we should be, but there's always that risk out there about removing or reducing that tax-exemption status from munis. You will probably hear that come up over the next, call it, six to nine months. I don't think it's realistic to remove that tax-exemption because it would make the municipal debt issuance prohibitively expensive. So you're putting a lot of these small state and GOs, you know, in a position where they have to issue higher yielding debt all else equal if that muni tax exemption is removed. So if we do hear about that, I'm still saying it's a very low probability of that being removed, but stranger things have happened when you're dealing with Congress, right? So we probably will hear about it, but I'm still giving it a very low probability of actually happening about that exemption being removed.

Jeffrey Buchbinder:

Yeah, I'd put that pretty close to zero. I mean, if they haven't been able to get rid of carried interest as a loophole yet, where generally people agree, then this one would be even tougher. So, yeah, a lot of headlines, political talking points, theatrics, and all of that. But yeah, it's about what's going get done and that one won't get done. So thanks for that Lawrence. So again, Weekly Market Commentary on those topics, implications of the election on Munis, pretty positive outlook there. Let's turn to the Fed, which of course is related to munis. I think pretty much talked about the Fed in every comment we've made thus far. So again, I think it's important to look ahead beyond Wednesday, but for now, that's certainly what people care about. Markets pricing and aggressive cutting. Lawrence, I mean, six cuts by January? That seems overdone again. The federal funds rate just seems to have actually, and the Fed itself, seems to have just an awful track record of predicting rates far in advance. What do you think?

Lawrence Gillum:

Yeah, yeah. We've seen the charts where markets are expecting one thing to happen and what actually happens is completely different from what was expected. I think we're probably in a similar type situation. Markets are pricing in a lot of rate cuts, not only over the next five months, but over the next call it, 12 to 14 months. Markets have taken the fed funds rate at the end of 2025 back down to 375. I'm sorry, back to 275. So it's a number that is about what some economists have said is neutral. There's other folks out there, I'm in this camp, where I think the neutral rate is higher now. So I think if, you know, the pricing, that's occurring in the interest rate markets, I think is overly aggressive,

Lawrence Gillum:

absent to recession, which we've talked about, which we don't see. But as it relates to this week, you know, markets are... The Fed's in a difficult situation right now. Wednesday of last week, there was probably a 10% chance of a 50 basis point hike. I'm sorry, a cut this week. But after the Wall Street Journal reported and the Financial Times reported that policy makers are still unclear about the size of the rate cut this week, pricing has increased to about 65% of a 50 basis point cut on on Wednesday. The Fed doesn't like to disappoint markets. So either this was leaked. The notion that we could see a bigger than 25 basis point cut, maybe that was leaked. Maybe that was honest reporting saying that the Fed just doesn't know yet. But either case, there's going to be a disappointed market, whether it's 25 or 50, because the fed funds rate or the probability of a 50 basis point cut isn't a hundred percent, and it's not zero. Typically, when we get to this period right before the Fed meeting, it's close to one of those probabilities. It's 64% right now, which means there's going be some disappointment in the markets. So this one would be interesting to see.

Jeffrey Buchbinder:

Yeah. I also think it's interesting that the gap between the two-year Treasury yield and the fed funds rate, I think is, is at record levels,

Lawrence Gillum:

Right.

Jeffrey Buchbinder:

Right? So actually this point comes out on the next chart. They are, I mean, whether you think neutral is three or four or even less, they have a lot of cuts they need to do to get to neutral. You could even make an argument that they should be a touch below neutral in six months. Right? Based on the economic outlook right now. They have a lot of cutting to do. You're probably better off cutting 50 earlier rather than later, I would argue. Right? Because a 50 base point cut later is more likely to be too dovish. Right? Whereas a 50 basis point cut now really doesn't carry much risk in my view. You're still going be restrictive after you cut 50. That's very clear. What do you think about that argument for 50?

Lawrence Gillum:

I think, yeah, no. I think that's right. I'm certainly sympathetic to that view. The institutional, you know, reaction has been 25 basis points cut per meeting in this type of scenario. So there's... I hear these concerns about the Federal spook markets. If they cut 50 basis points, they'll be more concerned than what markets are pricing in and more concerned about the economy than perhaps markets are. I mean, I get that. Then you have the election too. Cutting 50 basis points this close to an election. Does that, you know, have any sort of political bias associated with it too? So I've been in the 25 basis point camp. I've been saying and thinking that 25 basis points cuts for the next three meetings for the rest of this year makes sense. But I could totally see the argument. Bill Dudley came out with an op-ed in Bloomberg today about the need for 50 basis points. So I think the narrative has increased about that. The narrative has increased around that 50 basis point cut. We'll see how it how it plays out but, like I said, either way markets are going be disappointed.

Jeffrey Buchbinder:

Yeah. And Dudley, former New York Fed Chief. Right?

Lawrence Gillum:

That's correct. Right.

Jeffrey Buchbinder:

So he has some credibility and I think that combined with Wall Street Journal, where Nick Timiraos at the Wall Street Journal has some Fed street cred, those two factors, I think, you know, pushed us to where we are right now. So this is going be one of the more interesting Fed meetings in a while. If, regardless of whether they cut 25 or 50, the messaging is going be very, very important to guide the markets, you know, so that the folks who are maybe disappointed aren't as disappointed. Right? We'll have to wait and see. So this chart we kind of touched on it, but the Fed funds rate is, at least this concept, fed funds rate is nicely above inflation now. Right? It's also nicely above the two-year yield. So that tells you that the Fed is too restrictive and they need to cut.

Jeffrey Buchbinder:

It's obviously good news that inflation's come down. Hopefully it'll continue to come down and that will make the Fed more comfortable cutting. So just another way of reiterating the point I just made about that gap, right, between where the Fed is and where all of these sort of indicators suggest they should be. So that's of course the biggest event of the week, and but it's not just the Fed, Lawrence. I know we get the Bank of Japan this week, we get the Bank of England this week, I think, and there's also some pretty important data in retail sales, which, you know, it's not all of consumer spending. It's not... You can't say it's two thirds of the economy or 70% of the economy, but it's a decent sized chunk. I think it's 15 plus percent of the overall economy. So it matters. What should investors be focused on in terms of the economic counter?

Lawrence Gillum:

Yeah, for sure. It's about the Fed and maybe tangentially related to that with other central banks, with the Bank of England and the Bank of Japan. Neither of those central banks are expected to change policy. But there could be some additional commentary coming from those central banks. But to your point, retail sales is, call it, the last important data point before the Fed releases its decision. The expectation is perhaps maybe retail sales comes in a bit softer than expectations. Or I guess the whisper number is the retail sales number comes in a, a little bit softer than expectations. So if that does happen, maybe that swings the pendulum to a 50 basis point cut by the Fed. If not, maybe pricing goes back to a 25 basis point cut. But what's particularly frustrating about this economic data and the Fed's reaction function, it's become very data point dependent. So I mean, the fact that we're talking about retail sales the day before the Fed releases its data as, you know, a potential market mover, I think is problematic for investors. So the advice is, you know, volatility is going stay elevated until the Fed figures out what they're going do. And, you know, the story for investors is, you know, perhaps look past the noise if you can, and, you know, stick to your longer term investment thesis because... we do think volatility is going stay elevated for both the equity and the bond market, frankly, given the the indecision from the Fed right now.

Jeffrey Buchbinder:

Yeah. So what do you expect from the dot plots or from the sep, you know, the summary of economic predictions, might that change if people want to look out to 2025? Which frankly I think is what they should be doing.

Lawrence Gillum:

Yeah, no. For sure. I mean, that's the big thing for fixed income markets. I mean, we talked about this, but it's not about September meeting in terms of rate cuts, it's what the longer neutral rate is expected to be. We'll get that information from the dot plot. The dot plot, as a reminder, is the individual members on the FOMC, the Federal Open Market Committee, and their expectations for where the fed funds rate's going be at the end of each year. We also get new economic projections for growth inflation, the unemployment rate. We're already at some of those levels that that was released last June. The summary of economic projections is released on a quarterly basis. So the inflation story, the unemployment rate and the growth story will all be updated here.

Lawrence Gillum:

So we'll get more information on how the Fed's thinking about the economy. But the dot plot is going be a potential mover for the fixed income markets, given what's already priced in, in terms of the longer expectation for fed funds. I mentioned the markets expect the fed funds rate at the end of 2025 to be 2.75%. That is vastly different from what the Fed gave us in June in terms of what their expectation was for the fed funds rate in 2025. So there's going be a reconciliation, either the Fed changes or the market changes. So we'll see how that comes out on Wednesday.

Jeffrey Buchbinder:

Yeah, it seems like they might both be wrong by the time we get to early 2025. We'll see. That's still a ways away. We still got to do our Halloween holiday, our Thanksgiving holiday, and Christmas, et cetera. So we want to look intermediate to long term, but certainly we have to focus on what the near term, what each data point tells us about where we might be headed. So that's really what matters. This week, we do get some housing data, and of course, we've got to continue to watch the job market. So claims is kind of steadied in that 230 range. But we'll always watch claims as we are nearing an inflection point on the Fed. So with that, we'll go ahead and wrap. A lot of great content from you this week, Lawrence, so thanks for walking us through munis. Maybe a little more of an exciting topic than people thought. And thanks for all of your insights on the Fed. I know you've been, you're a young guy, but you've been watching the Fed for a long time, so I really trust your take on that. So thanks everybody for listening. Thanks as always for joining us for Market Signals, and we will be back with you next week.