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Examining the Fed, Inflation and Interest Rates: An Update for Fixed Income Investors

Douglas Gimple

In our recent podcast, we unpack the latest from the Fed, inflation outlook, interest rate forecast, and more. Discover historical context on tightening cycles and fixed income returns over 3 years post-hikes. Plus, a deep dive into risks, opportunities and attractive areas of the bond market. (22 min podcast)

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Jessica Schmitt (0:05)

Hello, everyone! I'm your host, Jessica Schmitt, Director of Investment Communications here at Diamond Hill, and welcome to another exciting episode of Understanding Edge. Today, we're once again joined by our resident expert, Douglas Gimple, senior portfolio specialist for our fixed income team here at Diamond Hill.

Today's episode is all about understanding the current climate — we'll be unpacking the latest moves and comments by the Federal Reserve, taking a close look at the present state of inflation, and getting to grips with the interest rate outlook. We'll also be exploring how these factors could impact you, our fellow fixed income investors.

Whether you're a regular listener or tuning in for the first time, this episode promises to provide you with valuable insights and actionable advice.

So, sit back, grab a cup of coffee, and let's dive right in. Thank you for tuning in, and we hope you enjoy this engaging conversation with Douglas Gimple.

Jessica Schmitt (1:10)

Hey Doug, great to have you back on the podcast.

Doug Gimple (1:14)

Thank you for having me as always. Looking forward to a fun conversation.

Jessica Schmitt (1:18)

Good. As you may tell, I'm a bit under the weather, so I'm going to do my best here. Good thing you are the one that does the majority of talking on our podcast, so let's dive straight into it.

We're going to start with a topic of broad interest today, Doug — the recent Federal Reserve decision. Earlier this month, we saw that they held rates steady, but Federal Reserve Chairman Jerome Powell hinted at potential increases down the line, particularly in light of the fact that the current inflation level still is far above their target. Could you break down for us the key points from this month's meeting and some of the implications that those might have for our listeners who are invested in fixed income?

Doug Gimple (2:04)

What's most interesting about the Fed lately is the fact that they're not really doing anything. And I don't mean they're not doing anything, but from a rate standpoint, the thing that people expect, they've held the line, and the real interesting part of it is that really since their last meeting when they did an increase — so go back to July 26 of this year — that was the last time they did an increase. Since then, they've been on hold, but as they've been on hold, the 10-year treasury has climbed from 3.87% on that day to 4.93% at the end of October. So we've seen this huge move on the longer end of the curve; the shorter end's moved as well but hasn't moved as much. It's gone from 4.75% to 5.09%. So, the meeting was kind of as we would've expected: a lot of talk about we're going to wait and see, data dependency, we reserve the right to go higher at some point, but they're still digesting.

What does it mean with the longer end moving so dramatically without them really doing anything? And is it enough to slow things down to where maybe they don't need to raise again? We had strong third-quarter data, jobs was strong again and continues to be so. You've got some of the more hawkish policymakers that are, they're now out, I refer to it, they're out in the field, they're doing the talk show circuit, or they're giving speeches, and they're discussing the move in longer rates and how it could have a dampening effect on the rest of the economy. We've seen it with mortgage rates hitting above 8% and then more recently coming down. But you've got Dallas Fed President Lorie Logan, Governor Christopher Waller, and Governor Michelle Bowman — they've all been using speeches to kind of communicate that it's too soon to know what the full effects of these increases on the longer end are going to be.

Neel Kashkari came out with a more creative way of talking about it, and he's a Minneapolis Fed president, and he joked that the term premium, which is what a lot of people have been talking about, is kind of the economic version of dark matter — the residual of stuff that the Fed just can't explain. And so he acknowledged there are a number of factors that are driving up yields, but he's not comfortable with saying that what they're going to do in this current environment.

So again, no surprises from the Fed meeting. I think the most surprising thing was a couple of days later when Powell was interrupted by some climate activist at a speech he was giving, and he dropped some pretty salty language, which for a man as mild-mannered as him to hear that coming out of his mouth was pretty surprising. But otherwise, everything's kind of status quo.

It's we're going to wait and see. He acknowledged that the dot plot that came out in September, which I've always talked about, ages out about five minutes after it comes out; they're really leaning towards just kind of this long pause, and they keep saying pause and not stop, meaning that there could be a rate hike, but we've got to see what inflation's doing. As I mentioned in the past, it doesn't go down a straight line. We've seen some of that kind of movement, but it's just kind of wait to see, and no surprises really from this last Fed meeting at all.

Jessica Schmitt (5:34)

Okay. Well, in your latest monthly commentary, Doug, which is available on our website, it's titled Fixed Income: Examining the Past to Understand the Future. You take a look at some historical tightening cycles from years past to help us understand where today's fixed income markets might stand relative to history. Can you highlight for us a few of your takeaways from that analysis?

Doug Gimple (5:58)

Certainly, as we all know, and I'm forced to say, which I would say anyway, but past performance is not indicative of future returns. So this wasn't an idea to say, here's where we're going to go from here based on what's happened in the past. It's more this is what's happened in the past and it may serve as a roadmap as to where we may be going. So, for reference, I looked at three years forward from the stopping of rate hikes and really how the Bloomberg US Aggregate Bond Index performed over that time period. So final rate hike from that point three years going forward, just to clarify. The periods I looked at were the 1999-2000 tightening cycle, the 2004-2006 cycle, and the most recent 2015-2018 cycle.

Didn't want to look at this cycle because we may not be done as we were just talking about. But each of these time periods had their own significant market events, and that's ranging from 1999 to 2000s dot-com bubble and the 9/11 terrorist attacks to 2004-2006, which was really the lead-up to the financial crisis and the European debt crisis. And then 2015-2018 was that emergence from the zero-interest rate policy that we had had for many years, the slowdown in global growth, and then the COVID-19 pandemic, which we worked through the last several years. So obviously, no period is the same, but the three-year time period going forward covers the eventual subsequent loosening of rates as part of the ongoing economic cycle. You tighten, you loosen, and you rinse and repeat, I should say. But during those time periods, fixed income markets delivered significant value to investors.

So from 1999 to 2000, three years forward returned a little bit more than 37% on a cumulative basis, which works out to just north of 11% on an annualized basis. 2004-2006 was nearly 21% cumulative return and about a 6.5% annualized return. So that's over three years again. And then 2015-2018, going forward three years, cumulative return of about 14.6% or roughly just under 5% annualized returns.

So, some pretty compelling numbers just coming off of those periods of tightening. But consider that right now, and we've talked about this in the past, we're coming off two consecutive years of negative performance for fixed income. That's never happened before, and we've got the very real possibility of a third year, 2023, we're not done yet, and just coming in this morning, today's the 13th of November, we're still negative. I think we're negative in the mid-40-type basis points.

So, the pain that the markets have felt has really been unprecedented in fixed income, but we're also in one of the best positions relative to the past regarding current interest rate levels. So, if you think about it, we've gone through this pain, we're now at levels where the Bloomberg Aggregate is yielding somewhere north of 5%, almost 6%. You've got that potential if there's a stabilization in rates — and they're never truly stable — you'll have day-to-day fluctuations. But if we're in maybe a trading range going forward or even contraction, you've got really attractive yield levels complemented with possible principal appreciation if we do see rates start to come down. If the Fed, and I'm not making any kind of call in any way, but if the Fed starts to cut rates by the end of next year, I'm not thinking it's going to be anytime soon, but if by the end of next year they start, then you've got not only the yield level that you're getting right now, but you've also got that principal appreciation if we see rates contract.

So again, it's not to say that what we saw in the past is what we're going to see in the future, but given where we are right now in the cycle, fixed income looks as attractive as it's been in a very long time.

Jessica Schmitt (10:11)

That is good news for fixed income investors should that play out. One of the areas that I think continues to be a point of concern as interest rates move up and inflation is higher is the consumer and the health of the consumer. And we've spoken about this in previous podcasts, and you've commented on things like the current savings rate and consumer-related debt performance. What are we seeing in that area today, and have there been any meaningful shifts?

Doug Gimple (10:43)

Well, the trend is increasing defaults and delinquencies, which again is part of the cycle. We're just now getting to — depending on what part of the market you're looking at with regards to the consumer —we're either just getting to pre-pandemic levels or pushing a little bit past pre-pandemic levels with regards to delinquencies and defaults, and that's really surplus savings have dried up. We had the savings that the government was throwing at us during the pandemic, three different stimulus checks, and now consumers are starting to turn to credit to keep up some of their spending habits.

Underwriters have continued to tighten their standards, and we see that change reflected in various vintages. And the most obvious is when we look at later 2021 and early 2022, those consumer-related securities aren't performing as well due to the loosening of standards that we saw during that time period — as they were looking to issue more and more, they loosened up some of those underwriting standards.

So, security selection is even more important now when it comes to consumer-related debt. We saw the issuers start to tighten up again, and we've seen performance rebound, so maybe not giving as much debt or as much available debt to consumers that maybe shouldn't be getting it.

Now more than ever, it is important to have a complete understanding of the issue, their approach to risk management and the history of underwriting, as well as the overall structure of various deals. Stronger credit enhancement is key if we believe things are going to slow down overall, and we've seen that already how they're structuring these deals.

I contend that even though it appears that we may have avoided a steep recession, and I'm not saying that we're free and clear, anything can happen. There's a definite bifurcation in the economy, and I know we've talked about this in the past, but subprime borrowers, lower-income families are feeling the pain of inflation, and it's very real.

And I'm sure if you ask them, they consider themselves in a recession because of the impact of inflation, because of having to decide, “What am I going to pay for this month?” That's becoming a real issue. While you look at middle to upper income, maybe they've adjusted how they're spending. Unfortunately, I went to the mall this weekend — packed — and people were spending, but I think that middle and upper income, as I said, they're starting to shift maybe their spending habits, but they're still spending, they're still going on vacation.

I read this morning's headline that they're expecting that this Thanksgiving is going to set records with regards to travel, which makes me very happy that I'm staying home, but that means that people are spending money. And so, there's that bifurcation.

I think that's going to be important as we move forward when it comes to looking at risk, when it comes to looking at credit quality across the spectrum of consumer debt, and making sure that you're making that right choice with your due diligence and what you're investing in.

Jessica Schmitt (14:03)

And I imagine we'll see some more interesting notes as we move through the holiday season and we see how that spending trended up or down compared to historical years as well.

From your perspective, Doug, you talked about potentially a rosier picture for fixed income investors coming forward, but from your perspective, obviously, there are different pockets, e.g., consumer, real estate, that remain a little bit higher risk. What do you see are some of the main risks? And then, of course, on the other hand, opportunities for fixed income investors over the next, let's call it 6 to 12 months?

Doug Gimple (14:47)

Yeah, I think the biggest risks to the market are most likely outside of the market. And what I mean by that is the geopolitical situation around the globe is probably the worst it's been in decades. You've got the ongoing war in Ukraine, you've got the terrorist attacks in Israel, and the subsequent response from the IDF; it's a horrible situation. And the biggest global concern is the conflict spreading beyond Israel and Gaza to encompass the entire Middle East potentially dragging in outside countries like us or Russia. And so that, I think, is one of the biggest concerns and one that we really have no control over because anything can happen.

And so, we're heading into also this is not, well, it's political, but not geopolitical. It's not broadly speaking; it's here in the United States. We're headed into what could be the most contentious election cycle that we've ever seen. Regardless of your political affiliation, there's enough animosity between the parties that this could be even worse than what we saw in 2020, and that was really bad. We're still feeling the ramifications of that.

From a market standpoint, so looking specifically at the market, there are concerns about commercial real estate — that's going to continue, and it's amplified by the looming maturity wall from 10-year deals that originated between 2013 and 2015, as well as a specter of corporate refinancing. A lot of companies, a lot refinanced during the early days of Covid because rates were compressed and it was really cheap. Well, those three- to five-year maturities are going to be coming up, and we've had this dynamic shift in rates, and that's going to impact refinancing. So, it's the concern about broadly speaking about the globe and then market specific, I think commercial real estate, I think, and that's not news to anyone. We know that there have been issues there and then on the corporate side.

But if we can kind of soft landing, no landing, however you want to call it, if we can work through the next 12 to 18 months, I think that we're going to be in pretty good shape, but there probably will be some pain. And I would also note that whatever it is that disrupts markets is the things that we never really expected. So there's probably something out there that we should be worried about that we don't even know, and that's usually how it functions.

Jessica Schmitt (17:19)

Sure. In diving into a little bit of Diamond Hill’s fixed income strategies, are there any particular areas of the bond market that the team is finding some relatively attractive opportunities right now?

Doug Gimple (17:34)

Yeah, this won't come as a shock to listeners, but we continue to find value the securitized market. The tightness in the corporate market that we discussed last month and we wrote about in our previous commentary (Corporate Bond Market Dynamics Amid Fed Tightening) it continues. While spread levels in the securitized market continue to, we believe, add value. Specifically, agency residential mortgages continue to trade at levels that bear a resemblance to what we saw in the financial crisis, whether that's due to the Fed continuing to reduce their balance sheet or the impact of rising rates on legacy resi-mortgages. Whether it's low coupon legacy mortgages trading at a significant discount or last cash flow, current high-coupon mortgages. We believe there's value to be had if you know where to look and you have the patience. If you're looking at agency resi mortgages, you're not worried about credit. If you assume the government's going to be there, then you don't have to worry about the credit aspect. You just have to worry about cash flows, and when am I going to get paid.

We talked about it just a bit ago, but commercial real estate continues to look attractive as really the entire sector has been hit pretty hard with all the negative headlines. Even the well-structured deals that are holding up well, they're feeling the pain, and it's kind of just everything being painted with a broad brush, which offers opportunity.

Think about office, and everybody's worried about office, but you've got solid class-A office properties with near-full occupancy and solid markets. They've widened considerably. That's offering some value, but it gets back to understanding what you own, being very selective, and not just buying broadly in the office space but selectively picking and choosing where you're going to be.

We talk about relative value, so consider that CMBS are trading at similar spread levels to corporate deals, two rating levels lower than their corporate brethren.

So, for example, and I'll use this, and I used it previously, but I updated the numbers. The Bloomberg US CMBS AAA Index ended the month of October with a spread level of around 118 basis points. So, what you're getting paid over comparable duration Treasuries taking into optionality.

The Bloomberg US Corporate A-Rated Index — so again, two notches below that CMBS example — finished the month with an OAS or option-adjusted spread just over 115 basis points. So, you can get higher quality, better structured CMBS for a similar yield to lower-rated corporate debt. So, you're getting higher quality, better structure, hard collateral, and you don't have to go down to single-A, which single-A isn't necessarily something to worry about, but you can stay higher quality. And so that's kind of the opportunity that we're seeing. It's not to say that we're not going to be investing in corporates; we do, but on that relative value basis, we're finding more opportunities in the securitized market than we are in credit.

Jessica Schmitt (20:45)

Okay. Well, Doug, those are the questions I had for you today. I look forward to touching base with you. I believe we'll probably touch base one more time in December. Call it a year-end review and outlook perhaps, and we'll continue to hope that the rosy picture is in our future for fixed income investors. So thank you for joining.

Doug Gimple (21:03)

We're all hoping that, and I hope everyone, including yourself Jess, has a wonderful Thanksgiving.

Jessica Schmitt (21:09)

Thank you, Doug. Talk to you soon.

Bonds rated AAA, AA, A and BBB are considered investment grade.

Bloomberg US Aggregate Bond Index measures the performance of investment grade, fixed-rate taxable bond market and includes government and corporate bonds, agency mortgage-backed, asset-backed and commercial mortgage-backed securities (agency and non-agency). Bloomberg US CMBS AAA Index measures the market of US agency and US non-agency conduit and fusion CMBS deals rated AAA with a minimum current deal size of $300 million. Bloomberg US Corporate A-Rated Index measures the single-A rated, fixed-rate, taxable, corporate bond market. The indexes are unmanaged, market capitalization weighted, include net reinvested dividends, do not reflect fees or expenses (which would lower the return) and are not available for direct investment. Index data source: London Stock Exchange Group PLC. See for a full copy of the disclaimer.

The views expressed are those of Diamond Hill as of November 2023 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.

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