Was the Fed’s November Pause an Ease in Disguise?

Leland Abrams, who serves as Chief Investment Officer for the investment manager Wynkoop LLC and a portfolio manager of a fixed income strategy at Catalyst, provides his analysis of the Federal Reserve’s Nov. 1 meeting and press conference below:

The Federal Reserve decided to leave benchmark interest rates unchanged at 5.25 – 5.50% on Wednesday.  However, there was a decided shift in Chairman Powell’s tone and a small tweak to their press release language (noting the financial conditions have tightened since their last meeting).  On the heels of the press conference Q&A session, the entire interest rate curve rallied significantly.  At the last Fed meeting, while they did not raise the benchmark rate, their language and dot plots via the Summary of Economic Projections release acted as a shadow raise.  That ‘shadow raise’ was taken away yesterday by a ‘shadow ease’.

Was Wednesday’s pause actually an ease?  Since September, interest rates have been on a meteoric rise, particularly the longer end of the duration curve.  The curve had been deeply inverted, and via a bear-steepener, the curve dis-inverted from -110 all the way to around -10 (2s / 10s spread).  Chairman Powell said the ‘dot plots can decay’, which effectively removed the idea of one or two more hikes, as indicated in September’s Summary of Economic Projections.  We believe the Fed is finished raising rates, which suggests the next move would be a cut.  The futures market is now pricing in only 6 bps higher rates through January 2024, while just two weeks ago, the futures market suggested an over 50% chance of another 25 bp rate hike.

Deeply inverted yield curves typically portend recessions -we believe they actually cause recessions.  The fact that short-term funding costs exceed long term liabilities makes most financial structures not work.  The resultant tightness of credit ultimately makes its way into restricting economic activity.  This process takes time; typically 12-18 months.   We have now had an inverted yield curve for around 15 months.  The dis-inversion of the curve is more telling historically that a recession is around the corner.  Only once in the past 65 years (1968) has a bear-steepening dis-inversion (where 2-year note yields are relatively unchanged and the long end rises by 50+ bps) not predated a recession.  Time will indicate if this recent phenomenon adheres to history’s track record or is an outlier.

There have been prominent investors who have come out speaking about the bond market in the past two weeks.  Bill Ackman covered his short, Bill Gross is buying June SOFR futures (bullish on short end of curve), Stan Druckenmiller put on a ‘massive’ bullish bet on the 2-year note, and Jeff Gundlach is ringing the recession bell while he believes a new bond market rally is underway.

Historically, the Fed eases 7.6 months after its final hike.  If July 2023 was the last hike, then March 2024 could be the first cut.  Also, the Fed does not typically cut in small increments. We expect if the economy deteriorates, cuts could be much deeper than those indicated by the futures market or the Fed’s SEP.

The strength of the third quarter is in the rear-view mirror and all signs point to a significant slowing in the fourth quarter.  This weeks’ ISM data was decidedly negative / recessionary, leading economic indicators have negative for over one year (typically predict a recession), and today’s economic releases do not bode well either.  Despite the rhetoric of a strong labor market, cracks and fissures are emerging.  Unit Labor costs fell -0.8% versus positive estimates and coming off a strong +3.2% from the second quarter.  Weekly job claims came in higher than estimates, but more importantly, the continuing claims number has slowly been inching upwards over the last several weeks.  Durable goods orders also came in slightly below expectations today.

Will the next move by the Fed be a cut?  When will it come?  As of today, the futures market is saying there will be a cut around June 2024.  Time and data will tell …

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Leland Abrams, Portfolio Manager
Leland Abrams, Portfolio Manager
Leland Abrams serves as Chief Investment Officer for the investment manager, Wynkoop LLC. Leland is Lead Portfolio Manager of an NARMBS income-oriented fund at Catalyst Funds. Prior to joining Wynkoop in September 2016 as Principal and Portfolio Manager, Mr. Abrams spent five and a half years at Candlewood Investment Group LP. Most recently, he was the RMBS Sector Manager responsible for overseeing approximately $1 billion in RMBS investments across the firm. Previously, Mr. Abrams spent two and a half years as a non-agency mortgage and esoteric ABS trader and credit analyst at United Capital Markets, Inc. Prior to that, Mr. Abrams was a Credit Analyst and Trader at Dresdner Bank, AG (Dresdner Kleinwort Wasserstein). Mr. Abrams holds a B.A. in Economics from Bucknell University. Mr. Abrams served as a Director and member of the Audit Committee for Front Yard Residential Corp, a public REIT headquartered in Christiansted, VI until the company’s sale in January 2021.

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