Monetary Policy: Recalibrating Expectations in Q2
Second Quarter, 2024
John R. Sides, CFA
For fixed income investors, 2024 has largely been defined by a recalibration of monetary policy expectations. This was on full display as another previously expected Fed cut was priced out of the futures market during the quarter. On March 31st, almost three Fed Funds rate cuts were expected by year-end. By the end of June, expectations had fallen to less than two cuts. Inflation data still well above target, a resilient consumer, and sturdy domestic growth were to blame. Interest-rate volatility reigned supreme.
Despite the encouraging disinflationary trends in both core PCE and core CPI (which excludes food and energy prices), they remain well above the Fed’s stated 2% target. The May reading of core CPI at 3.4% year-over-year is down from 3.9% at the beginning of the year. While the 10-year Treasury yield rose 20 basis points during the quarter from 4.20% to 4.40% – a seemingly innocuous rise averaging about 7 basis points per month – there were significant intra-quarter swings in yield. The yield curve steepened, mostly in the final two weeks of the quarter with the 30-year Treasury bond up 22 basis points and the 2-year Treasury note up 13 basis points. Investment grade corporate credit spreads remain at tight levels even after a brief pull-back at quarter-end. Buyers of investment grade corporate bonds are primarily attracted to their historically elevated nominal yields, which look particularly attractive for the high credit quality. Sellers of corporate bonds are pointing to tight credit spreads, rotating into sectors like agency MBS.
So where do we stand today? The bond market has been singularly focused on the Fed and the forward path of monetary policy. While that remains the dominant theme, investors now must contend with a looming Presidential election in November and the potential for a shift in domestic economic policy. Even as equities power higher, it is difficult to see a case where corporate credit spreads tighten dramatically from here. Credit selection remains imperative. Many corners of the securitized markets continue to offer relative value to both Treasuries and corporates, namely residential agency MBS. The market remains convinced that the Fed is going to cut their policy rate by roughly 50 basis points before year-end. Investors will continue to parse inflation, growth and labor data as they read the Federal Reserve tea leaves this summer.
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