Slightly more hawkish language makes analysts think cuts are less likely to come as soon as some investors had hoped
It didn’t surprise anyone last week when the US Federal Reserve decided to hold its key interest rates steady. What may have surprised some was the slightly more hawkish tone from Federal Reserve Chair Jerome Powell after he appeared to make a dovish pivot and predicted some future rate cuts following the Fed’s final meeting of 2023. The announcement press release featured a heavy focus on inflation, and at the post-announcement press conference Powell dismissed the possibility of cuts coming at the March meeting.
“It smelled to me like [Powell] was stepping back from his pivot-esque discussions in December,” says Rose Devli, fixed income portfolio manager at Dynamic Funds. “He kept talking about inflation, and it was very interesting to me that at the presser he said there was a risk that we settle on inflation above 2 per cent. I don’t think he had to mention that. There was no mention whatsoever on reducing quantitative tightening at this time, which I think was huge as well.”
Jobs remain a key aspect of Powell’s statements, according to Devli. She notes that whenever Powell talks about jobs and weakness in jobs he says that the Fed will cut more aggressively when they see a softening of the labour market.
Surprising US consumer resilience has been a regular story for months leading up to this announcement. In large part because consumers keep spending, we’ve seen US GDP growth exceed expectations as well. That data, Devli says, has given Powell some of the cover he needs to keep rates higher.
Sadiq Adatia, Chief Investment Officer at BMO Global Asset Management, sees the silver lining in the Fed’s announcement. While he thinks the language has muted the hopes some investors had of rate cuts in spring, the Fed has offered a definitive statement that, at the very least, hikes are over.
“You need that before you get to an eventual rate cutting environment. You’ve got to get a pause, and then a cut. The question remains on how long this pause is going to be before we eventually get a rate cut.” Adatia says. “This is where I think [Powell] was being smart not to say definitively when that might be, because it’s still going to be data dependent.”
Both Devli and Adatia agree that we will need to see unemployment in the US tick up more meaningfully, and inflation come down below that 3 per cent number before we see cuts of any kind. Inflation expectations are crucial too. If consumers think inflation will tick up again, the Fed may listen to that more than they used to. Adatia highlighted the risk of supply chain issues emerging from geopolitical tensions in the Red Sea, while Devli noted that China’s role as a potential source of deflation for the US economy could play a role.
As of now Adatia is predicting between four and six rate cuts by the US Federal Reserve this year, noting that when the cuts come they will come relatively quickly. Devli has a slightly different calendar in her outlook, predicting three cuts in 2024 and another three in 2025.
In terms of asset allocation, Devli now sees opportunities in the five to seven year section of the yield curve. She thinks that duration category has solid breakeven protection and strong yields by historical standards. She is a bit more wary of the long end of the curve at this point, given the run we saw in those bonds late last year.
From a broader standpoint, Adatia thinks that equities posting strong earnings will prove important for portfolios. As rates stay high, that will impact company balance sheets. Demonstrations of financial strength should be greeted warmly by equity markets. Dividends, too, will be a key component of total returns in a ‘higher for longer’ environment. He is particularly fond of financials, noting that while they could face loan loss risk, most of those risks were already priced in during their 2023 losses. The sector, Adatia says, seems poised for some recovery.
Both Devli and Adatia believe that this decisions drives home the importance of fixed income within a balanced portfolio. Inflation has come down to the point where bonds can reliably provide more uncorrelated returns now, and there may be opportunities to move out of some of the rising rate instruments that were so popular last year.
“A lot of people have been sitting in cash and GICs, that was fine in a rising rate environment because you were getting a pretty good yield,” Adatia says. “But we saw a different story last year, when we saw a perception of the Fed declaring an end to rate hikes, we saw good returns in the bond market and really good returns in conservative portfolios.”
