Jessica Schmitt (00:04)
Hello everyone. Welcome to another episode of Understanding Edge, brought to you by Diamond Hill. I'm Jessica Schmitt, Director of Investment Communications, and today I am joined by Douglas Gimple, our firm's senior portfolio specialist for fixed income.
In today's episode, we'll examine the Federal Reserve's complex balancing act, how it's navigating rising inflation, political pressures, and shifting market expectations in order to make data-driven decisions. We'll also explore the broader implications of these challenges for fixed income investors and discuss the potential path forward, including risks and opportunities in today's environment.
Whether you're a regular listener or tuning in for the first time, we hope this episode offers valuable insights. So, sit back, grab that cup of coffee or tea and let's get started. Thank you for tuning in, and I hope you enjoy this conversation with Douglas Gimple.
Jessica Schmitt (00:59)
Hey Doug, welcome back to the podcast.
Douglas Gimple (01:01)
Thanks, Jess, as always, for having me. It's a pleasure being here.
Jessica Schmitt (01:06)
Well, it's been four weeks since the Fed's last FOMC meeting where they chose to hold interest rates steady, and with no February meeting to recap, I thought we'd dive straight into your latest commentary, which actually focuses on a lot of the factors influencing the Fed these days, one of which is inflation, probably one of the bigger ones. So, I was hoping you could start us off by talking a little bit about what the latest inflation reading suggests about the Fed's potential next moves.
Douglas Gimple (01:35)
Well, Jess, as you know, we never try to predict what the Fed may do or when they may do it, but one thing that the markets do know — based on what the Fed has been telling us — is that they're most likely on the sidelines for the foreseeable future. The minutes of their most recent January meeting were actually released yesterday and it was pretty clear that data dependency is the way forward.
And I'm going to throw a quote out here, but the minutes stated that “Many participants noted that the committee could hold the policy rate at a restricted level if the economy remained strong and inflation remained elevated.” It certainly sounds like they've hit the pause button. The Fed also discussed the potential impact of the new administration's recent actions, including an increase in tariffs and a crackdown on immigration, both of which could be inflationary and detrimental to the labor market.
The effects of the change in trade and immigration policy, as well as a potential disruption in the global supply chain, are major risks that were key discussion points, though members stated the risks to the overall economy were fairly balanced.
One topic that I think has been pretty quiet recently, and it's been running in the background, is the state of the Fed's balance sheet and it's been winding down at a reduced pace since a shift by the Fed in June of last year. This was mentioned in the minutes of a potential stopping of the wind-down or a slowing of the process with a debt ceiling-fueled government shutdown potentially in mid-March, and we'll talk about that in a little bit. But Jess, as you know, I try to keep any kind of political discussion to a minimum, but comments and actions from the US president towards the Fed are something the markets are going to have to watch closely. A demand for lower rates on the same day that inflation was reported higher than expected and on the heels of a stronger-than-expected labor market report shows a slight disconnect with economic theory.
In client meetings recently, I've even been asked more than once about what would happen if the Fed were to actually increase rates as their next move. Academically, stubborn inflation coupled with a resilient labor market would be a combination for a more restrictive Fed, working to slow things down a bit, but I don't think that's an actual option despite that historic precedent. Jerome Powell and team have clearly communicated that data dependency will drive any future Fed actions regardless of the demands from the executive branch.
But let's go back to your original question about inflation. As you know, there are two main measures of inflation. The headline number, which is all-inclusive, and the core number, which excludes food and energy — two of the more volatile segments. Both methods of measuring inflation follow the same trajectory since peaking in the summer of 2022. But there's been a bit of a divergence between the two in more recent months, with an increase in food prices led by food-at-home inflation and the much talked about egg inflation. That was the highest since 2022 as well as an increase in energy costs. Headline inflation has been climbing since the fourth quarter of last year, albeit at a slow pace, specifically after bottoming out at 2.4% year over year in September. As of last year, the measurement for January, which was reported on February 12th, has climbed to 3%, its highest level since June of 2024. Core inflation, as I mentioned, excluding food and energy, has kind of bounced between 3.2% and 3.3% on a year-over-year basis since the start of the third quarter of 2024. The most recent reading for January came as kind of a surprise as the year-over-year level pushed back above, or I'm sorry, back up to 3.3% from December's 3.2% with a month-over-month increase of 0.4%.
Now, let's dig into that 0.4% number really quick. When we look at it and break it down, we can see that the actual increase, if you take it out to a couple of additional decimal points, was 0.446%, which is just shy of rounding up to 0.5%, which really, I think would've shaken up the markets. Price increases were broad-based hitting everything from insurance to used cars and trucks, airline fares, medical care, haircuts, daycare, sporting events, cable television, more. As it stands, the inflation report kind of jolted the markets upon its release, and I think it's an example of the upcoming volatility that we could experience during the year.
Jessica Schmitt (06:28)
Okay, well definitely a lot going on behind the scenes or in front of us today, but with that backdrop, Doug, how have fixed income markets been reacting so far this year?
Douglas Gimple (06:40)
January was a very interesting start, and I think it's indicative of what we could expect in 2025. If we look at the starting and ending levels for the 2-year and 10-year Treasury yields during the month, you really don't see much change. In fact, the 2-year Treasury ended the month of January just slightly lower than where it started at 4.22% compared to 4.25%, while the 10-year was essentially unchanged, 4.57% to 4.58%, but it was really the action during the month that tells the story of the fixed income markets in January.
There were really three key events that drove the volatility in the fixed income markets during the month of January. First rates jumped across the curve with the release of the December non-farm payroll report, which showed a gain of 256,000 jobs compared to the expected level of 165,000 jobs. It also included an increase of 34,000 in a revision to the prior month's report. On this news, the 2-year yield climbed by 13 basis points and the 10-year climbed by nine basis points on that day. Second, the December core inflation number came in at 3.2% year-over-year, which was a decrease from the November number of 3.3%. This fueled a rally across the curve with the 2-year Treasury yield lowering by 10 basis points and the 10-year lowering by 12 basis points.
And Jess, I just want to take a second here to make sure that I clarify. As I've been throwing around a lot of numbers with regard to inflation. The movement on January 15th that I'm referencing was for the December inflation report, which, as I said, was lower than the November report. Earlier, during your first question when discussing inflation, I was referencing the most recent January report that came out on February 12th that showed core inflation had once again climbed on a year-over-year basis to 3.3% and 0.446% month-over-month. The reaction from the market on February 12th was what one would expect from a higher inflation report yields on both the 2- and 10-year climbed higher, and it reinforced the idea that day-to-day volatility seems to be the theme in the early days of 2025. The key takeaway here is that core inflation in December came down from the November levels, but then immediately popped right back up in January.
The third event during the month of January was the DeepSeek mayhem near month end. We all remember Chinese AI company DeepSeek sent the equity markets into a tailspin in the final days of the month, and investors sought the safety of Treasuries, pushing both 2- and 10-year yields lower by 10 basis points.
But despite the volatility in the Treasury market during the month, spread levels for corporate and securitized debt continued to grind tighter as investors continued to search for yield. In the high-yield markets, returns were fueled by lower-quality higher-yielding segments of the market. As those lower tiers of credit quality led the segment, though all areas were up during the month. Spreads in high yield followed other spread sectors directionally but to a greater degree, with the Bloomberg High Yield Index spread compressing from 287 basis points to 261 basis points on a month-over-month basis.
For an understanding of how spreads have moved recently, consider that the average for the high yield index since the turn of the century is 511 basis points, and that includes the most recent period where spreads have been compressed. It's a similar story in the investment-grade space, with spreads closing out January at 78.6 basis points, which is significantly lower than the 109 basis point average since 2000, and I'm using the Bloomberg US Corporate Index for the measuring there.
But even with the volatility during the month, investment grade spreads held a pretty tight range between 78 basis points on the low end and 81 basis points on the high end. Really, the story of 2024 was a significant spread tightening across the securitized sector that really occurred throughout the year. That story has continued into the first month of 2025, with the various securitized sectors continuing to grind tighter.
Jessica Schmitt (11:30)
Okay, well let's talk about issuance trends for a moment, Doug. You highlighted some interesting trends in your monthly commentary, and I'll also mention that our monthly infographic, which you pull together as well, always has issuance trends for the securitized sectors. But what stood out to you about the first month's activity in terms of issuance both in securitized sectors or elsewhere, and what should fixed income investors take away from that?
Douglas Gimple (11:57)
I think the biggest takeaway is that despite all the uncertainty in the market and the bouts of short-term volatility, the markets are open for business. Investors are clamoring for product — whether it's securitized or corporate debt. The example that I've been using in meetings is there was a new issue corporate that came out just a couple of weeks ago, and the 10-year tranche of that new issue came to the market at a spread of 60 basis points over comparable duration Treasuries. So, I was talking about the levels for the overall index earlier in that kind of 78 to 81 range, and this new issue came out at 60 basis points of spread. The investment-grade corporate market saw $188 billion in new issuance come to the market in January, which is roughly an increase of 27% over the past four-year average.
In the securitized market, we've seen renewed strength in the non-agency residential and commercial mortgage-backed securities (CMBS) market while ABS (asset-backed securities) continues to deliver. The non-agency CMBS market brought $12 billion in new issuance in January, which is well ahead of 2023’s first-month issuance of $7 billion, and 2022’s of $2 billion. Single asset single borrower CMBS continues to lead the charge, accounting for roughly half the new issuance in the CMBS space. But not to be outdone, the non-agency residential mortgage-backed securities market brought $12.5 billion in new issuance in January, well ahead of both 2024 and 2023 start to the year. The asset-backed securities market set a record in 2024 with more than $320 billion in new issuance, and I've got a feeling that that record may only hold for a year. Through the end of January, the ABS market brought $33 billion in new issues, and February has been just as hot, with the first week of February being the busiest week for issuance since October of last year.
So, if we look at since the beginning of the year through the second week of February, the ABS market has already seen more than $51 billion in new issuance. Now, some of that is kind of front-loaded for February because things are going to cool down really next week, as the industry heads out to Vegas for their annual conference when issuance tends to dry up as everybody's out there. But we do expect issuance to ramp up once everyone gets back, but even with the surge in issuance across securitized markets and all of the supply out there, the spreads continue to grind tighter since the beginning of the year.
Jessica Schmitt (14:46)
Okay. Well, certainly it has been an interesting first couple of months from a market and fixed income perspective. Those are all the questions I have for you today, Doug. Any parting thoughts or insights you want to leave with our listeners before we go?
Douglas Gimple (15:01)
Well, Jess, we talked a lot today about the overall markets as well as some of the risks associated with various outside forces, but as we know, risks and volatility can also present opportunities for investors, and I believe that's really what we need to focus upon. A perfect example is the market disruption that occurred at the end of January with DeepSeek that I was talking about earlier. The NASDAQ and the S&P 500 lost more than 3% and 1.5% percent, respectively, on the day that the DeepSeek news hit, which was January 27th. But in the days following and through the middle of February, the equity indices that are referenced, they've already recovered more than the lost value of that day closing at higher levels as of February 18th. Meanwhile, in fixed income, the asset class behaved as it should providing some stability during a period of volatility for the rest of the markets, as the Bloomberg US Aggregate Bond Index returned 0.54% on January 27th, in part due to the flight to quality that I referenced earlier, and it's delivered around 0.12% in the days since.
But for those investors with a close eye on the market and the ability to take advantage of short-term volatility, it was a great opportunity to pick up some value. Now, when I'm asked about the risks for the rest of the year or our target level for interest rates in the coming months, I always respond that I don't know where rates or the markets will end up today, let alone six months or a year from now. Outside forces will always impact the market, many times surprising investors, and we're in an environment where it feels like there are even more than in prior years — ranging from the impact of stubborn inflation, the potential for tariffs, immigration reform, geopolitical events in both the Middle East and Europe, and uncertainty with government spending.
But these moments of uncertainty provide opportunity for investors, and that's why investors must remain focused on the long term and try to dampen that short-term noise. Don't forget, we're also potentially facing another government shutdown in the middle of March. I think it's March 14th is the actual date. And given the mood that we're seeing in Washington right now, I'm not so sure this is going to be resolved cleanly or quickly like it has in the past. 2025 has started out quite interestingly, and there's little expectation for that to change as we move through the year.
Jessica Schmitt (17:35)
Okay, Doug, well, thank you again for your insights and for joining us today. It's always great to speak to you.
Douglas Gimple (17:42)
It is always my pleasure to be here, Jess. Thanks so much.
Jessica Schmitt (17:46)
Well great. Thank you to our listeners. Doug and I will return for another podcast late next month. And in the meantime, for more insights and a full download of our latest market commentary and our infographic, visit our website at www.diamond-hill.com. Until next time, take care.