High Expectations for the Fed

by George Rusnak, CFA, Co-Head of Global Fixed Income Strategy

Key takeaways

  • Market expectations for a Federal Reserve (Fed) rate cut have risen, with fed funds futures signaling multiple rate cuts this year.
  • We believe the Fed will need to carefully craft its actions and communications this year, to address any gap between the “dot plots” and market expectations.

What it may mean for investors

  • We see the potential portfolio-buffering effects that high-quality fixed income can provide, should uncertainty occur. We favor aligning duration with investors’ selected benchmarks, and rebalancing portfolios to prepare for volatility.1

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Going into the Fed’s June 19 meeting, some bond market participants had built up expectations that the fed funds target rate could be between 1.50% and 1.75%, implying three rate cuts of 25 basis points each before year-end (based on fed funds futures).2 We forecast only one Fed rate cut by year-end. Further, the Fed’s median “dot plot” last week reflected no rate cut (although there was significant disagreement, with eight members projecting at least one rate cut this year). 

While the Federal Open Market Committee’s (FOMC) meeting release confirmed that the Fed is likely to be more accommodative going forward, we don’t believe that the Fed appears to be on pace to meet short-term market expectations. Further, the Fed’s messaging around any potential rate cuts may be challenging in coming weeks. We believe that it is important for investors to avoid “too much focus” on short-term market and interest-rate trends. Rather, it is best to keep a long-term view of the Fed’s changing direction—and rebalance portfolios appropriately.

Chart 1. Fed funds target rate probabilities for December 11 Fed meeting (based on fed funds futures)

Chart 1. Fed funds target rate probabilities for December 11 Fed meeting (based on fed funds futures)

Source: The CME Group, June 21, 2019.

Preparing for rate cuts

Although the Fed did not cut rates at the June 19 meeting, it may well have prepared the markets for a future cut by delivering fairly dovish messages through its statement, forecasts, and communication. All three aspects signaled a Fed whose members recognize that economic headwinds exist—and are willing to consider a more accommodative interest-rate policy to address them. 

First, the Fed removed the word “patient” from its statement and noted that it would “closely monitor” incoming information (which we believe could signal that the Fed is getting closer to an interest-rate cut). The “patient” term had been included in the Fed’s statements since January 2019—and as Fed members carefully consider the language in these statements, this “small” change has meaning.  Second, the FOMC lowered its inflation and future interest-rate targets for the second consecutive meeting (in its economic forecasts; see Table 1). The Fed’s year-end 2019 inflation (personal consumption expenditures, or PCE) target was reduced from the 1.8% March forecast to 1.5%, while 7 FOMC members believe there may be as many as 2 rate cuts required by year-end 2019. In March, no committee members believed that the Fed would need to cut rates twice this year. Third, Fed Chair Jerome Powell’s press conference communication after this month’s meeting signaled that the Fed has shifted toward lowering future rates. Most notably, Chair Powell did not “explain away” the Fed’s lower inflation expectations through a reference to transitory events. Rather, he acknowledged that lower inflationary data is a challenge with which the Fed is grappling. He also pointed toward trade-negotiation challenges and slowing global growth as issues the Fed is closely evaluating to see if they continue to deepen. Overall, Fed Chair Powell’s remarks suggested that the Fed may be poised to lower interest rates fairly soon—absent some key positive economic data.
Table 1. The FOMC’s Summary of Economic Projections: June 19, 2019

Table 1. The FOMC’s Summary of Economic Projections: June 19, 2019

Source: Federal Reserve, FOMC statement, June 19, 2019. GDP=gross domestic product.

The balancing act

As the Fed contemplates shifting direction of the federal funds rate, we believe it will need to do so carefully—so it doesn’t appear to be “pushed” by recent moves in U.S. treasury yields (or out of touch with those moves). Former Dallas Fed President Richard Fisher suggested last week that Jerome Powell was a leader who was likely to act as appropriate to sustain the economic expansion. Additionally, in our opinion the Fed needs to ensure it will not negatively impact current economic conditions (and market volatility), due to future rate-reduction expectations. For example, individuals might defer large purchases (such as homes) if they believe that rates will fall, or the market may face volatility as Fed policy differs from market expectations. The Fed’s credibility is at stake, and we believe that the Fed will need to increase the amount of communication—and the level of detail in its communications going forward—to help inform market participants about how the Fed is interpreting the incoming U.S. economic data.

Going forward

We believe that it is important for investors to recognize that the end of the “rate cycle” is fast approaching—and that the likelihood of multiple interest-rate cuts in future quarters is high. While it may appear that bond-market participants are being overly aggressive in terms of Fed rate-cut expectations—that may only be the case in the short term. Our base case is that there will only be one rate cut this year, but it is possible that the Fed could become more aggressive in cutting rates if economic conditions continue to weaken. Additionally, we would expect that the Fed is likely to cut rates again next year, after it evaluates the market impact of its strategy, barring an unforeseen events.

What can investors do?

We believe that investors should consider weighting their fixed-income investments in line with their strategic benchmark for duration and yield curve exposure. While we are favorable on short-term issues, we see the potential value afforded to investors by pushing out to the intermediate portion of the curve—in order to position for changing interest-rate conditions. We also see the potential portfolio-buffering effects that high-quality fixed income can provide, should uncertainty occur. We are currently unfavorable on high-yield corporate debt as we believe that investors are not being properly compensated for the credit risk they would take with excessive exposure to this debt class. We prefer investment-grade credit—and recently have upgraded mortgage-backed securities to favorable, given their recent spread widening and strong credit characteristics. We also believe that preferred securities can offer an attractive income stream potential (as interest rates recently have continued to decline), within a well-diversified fixed income portfolio.


by Scott Wren, Senior Global Equity Strategist 

Growth versus value

A growth stock is typically thought of as a share of a company that is consistently growing earnings at a rate significantly above the market average. Growth stocks tend to offer little, if any, dividend yield—and are often thought of as less sensitive to the ebb and flow of the economy. A value stock is a share of a company that is trading at a price lower than its fundamentals would suggest is warranted. Value stocks usually pay attractive dividends and are often viewed as more sensitive to the magnitude of economic activity.  

If you ask four different portfolio managers to define growth and value, you likely would get four different answers. Maybe that is why you may find one index provider categorizing a stock as a value issue and a different provider putting the same stock into the growth category. A company that is growing earnings at 4%—when the S&P 500 Index is signaling a 5% earnings decline—might be considered quite a growth stock; at least in that environment.

As the chart below illustrates, the Russell 1000 Growth Index has significantly outperformed the Russell 1000 Value Index since early 2015. Investors are wondering if this is likely to continue—or if it is time for value to shine. As growth slows later in a cycle, money tends to flow toward stocks that can steadily grow their earnings. Unless the U.S. economy accelerates significantly from here, we wouldn’t expect value to outperform until midway through the next recession.

Key takeaways

  • Growth has outperformed value since early 2015 (measured by Russell 1000 indices).
  • Our current allocations lean slightly toward growth sectors such as Information Technology. However, we are also favorable on Financials, which is a more value oriented sector.

Growth recently has outperformed value (as measured by the Russell 1000 indices)

Growth recently has outperformed value (as measured by the Russell 1000 indices)

Source: Bloomberg, June 19, 2019. An index is not managed and not available for direct investment. Past performance is not a guarantee of future results.


by Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy

Sovereign-bond rates are likely to remain low in the near term 

Central banks are shifting to a more accommodative tone. Nowhere is that more evident than in the eurozone—as Mario Draghi recently hinted that additional European Central Bank (ECB) easing measures would be forthcoming. As a result, many European countries' long-term bond yields dropped to their lowest levels ever. German 10-year bunds currently offer investors a yield of -0.32% (as of June 18, 2019). In other words, investors must pay Germany to lend it money.

In 2011, the 10-year U.S. Treasury note and the 10-year German bund both provided investors with a yield near 3.00%. Long-term rates in the U.S. have increasingly diverged from their European counterparts. Last week, the 10-year U.S. Treasury note offered investors 238 basis points of additional yield over a comparable German bund. While sustained yield divergence is likely, we believe that the magnitude of divergence is unlikely to rise substantially as investors search the globe for yield. With global rates at very low levels, investors should be prepared for an extended period of relatively low long-term U.S. interest rates.

It seems to reason that European yields should remain low until there is a reversal in economic trends that have developed on the continent. With global growth and trade concerns hitting business confidence, we believe such a turnaround seems unlikely in the near term, or even the intermediate term. In the longer term, we expect both global and U.S. interest rates to remain contained—as systemic issues such as an aging population and growing debt levels depress yields.

Key takeaways

  • It will be difficult for U.S. rates to diverge much further from European rates, given the influence of global yield demand.
  • We are neutral on duration, which should better position portfolios if rates continue to fall.
  • We remain unfavorable on developed market debt (ex-U.S.), given the extremely low (and even negative) yields that persist across much of the globe.

Divergence between 10-year U.S. Treasury yield and 10-year German bund yield

Divergence between 10-year U.S. Treasury yield and 10-year German bund yield

Source: Bloomberg, June 14, 2019. Past performance is not a guarantee of future results.


by Austin Pickle, CFA 

“It is not necessary to understand things in order to argue about them.” - Pierre Beaumarchais

Easy does it, gold bugs

The market consensus (and our expectation) is that the Fed will cut the target fed funds rate at least once in 2019. We have noticed that some gold bugs have used the fed funds futures market “certainty” of a rate cut as a reason to start chirping. The gist of their argument is that investors should buy gold, because as interest rates decline, the U.S. dollar tends to weaken—the opportunity cost to hold gold is reduced—and gold prices tend to benefit. We decided to take a look at past initial Fed rate cuts to determine if this argument holds any water. Our findings are below.

Initially, it seemed that the gold bugs were on to something—gold prices, on average, had positive returns after past initial fed funds rate cuts. But the key question to be answered is: has gold outperformed other assets after a rate cut? When looked at through this lens, gold loses its initial rate-cut luster. The chart illustrates this point by comparing the average performance of gold, stocks, bonds, real estate investment trusts (REITs), and commodities after initial Fed rate cuts. Notice how, over a one-year time period, gold underperformed all of these asset classes except commodities. Even bonds, a historically low-risk, low-return asset, handily outperformed gold, on average. 

We caution investors from using the Fed’s probable rate cut as a reason to pile into gold—other options have historically been a better choice for investment dollars. At $1400 per ounce, we do not see gold as any great bargain.

Key takeaways

  • Gold typically has underperformed stocks, bonds, and REITs after initial Fed rate cuts. 
  • At $1,400 per ounce today, we do not see gold as any great bargain.

Gold versus stocks, bonds, REITs, and commodities after initial Fed rate cuts

Gold versus stocks, bonds, REITs, and commodities after initial Fed rate cuts

Sources: Bloomberg, Ned Davis Research Group, Wells Fargo Investment Institute. Daily data: November 13, 1970 - June 19, 2019. Indexed to 100 as of the initial Fed rate cut date. The chart measures the average performance of each of the assets after the past 11 initial rate cuts since 1970 (8 since 1980 for bonds and 9 since 1974 for REITs). Gold is represented by the spot price; stocks by the S&P 500 Index; bonds by the Bloomberg Barclays U.S. Aggregate Index; commodities by the Thompson Reuters Continuous Commodity Index; REITs by the FTSE NAREIT All Equity REITs Index. Due to data limitations and availability, bond data was measured since the 1980 Fed cut and REITs since the 1974 rate cut. An index is not managed and not available for direct investment. For definitions please see page 9-10. Past performance is not a guarantee of future results.


by Ryan McWalter, Global Alternative Investment Strategist 

Structured Credit’s resilience to geopolitical risks 

Over the past 15 months, a key market-volatility driver has been an unstable geopolitical environment—specifically surrounding trade relations. The U.S. officially imposed tariffs in February 2018. Since then, more targeted tariffs have been imposed on China, along with tariff threats directed at other countries (such as Mexico).

For the period from February 2018 through May 2019, global equity markets declined by 5.72%, while the average hedge fund avoided about 60% of this downside (-2.29%).3

Over this period, the Structured Credit hedge fund sub-strategy outperformed global equity and high-yield corporate bond markets, with approximately 75% less volatility. The HFRI Relative Value Asset-Backed Index rose by 5.63% during this time.

The Structured Credit strategy invests in debt securities, such as residential mortgage-backed securities, commercial mortgage-backed securities, asset-backed securities, and collateralized loan obligations.  

While the Structured Credit strategy is sensitive to the economic cycle, we believe that it is somewhat insulated from broader macro risks, given its unique return drivers and strong fundamentals across many underlying sectors. These positive fundamentals include rising home values (an increase in home equity and homeowners’ incentive to continue paying their mortgages); favorable real estate supply/demand dynamics; low interest rates; historically low unemployment; and wage growth. We believe that these elements bode well for the strategy. We also believe that structured credit can provide useful diversification as the strategy’s cash-flow drivers are quite different from those for the broader equity and corporate bond markets.

Key takeaways

  • Since the initiation of U.S. tariffs in February 2018, hedge funds have avoided more than half of the global equity market’s downside.
  • Structured Credit has been a top-performing hedge fund sub-strategy since February 2018. We believe that this strategy is somewhat insulated from broader macro risks, given its strong fundamentals and idiosyncratic return drivers.

Structured credit fundamentals have been reflected in performance

Structured credit fundamentals have been reflected in performance

Source: Markov Processes International, June 20, 2019. RV = relative value. Chart represents performance since the U.S. imposed tariffs (February 2018–May 2019). An index is not managed and not available for direct investment. 

1Duration is a measure of interest-rate risk.

2One hundred basis points equal one percent.

3Based on the returns of the MSCI All Country World Index (global equities) and the HFRI Fund Weighted Composite Index.