Jessica Schmitt (0:01)
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 Douglas Gimple, senior Portfolio Specialist for our fixed income team here at Diamond Hill.
In today's episode, we're going to discuss the market's ongoing desire to fight the Fed. We'll touch on the latest from the Federal Reserve and the most recent inflation reading, and we'll also discuss the CMBS market and potential opportunities investors might find there and in other areas of the market.
Whether you're a regular listener or tuning in for the first time, we hope this episode offers valuable insights for you. So sit back, grab a cup of coffee or tea, and let's dive right in. Thank you for tuning in, and we hope you enjoy this conversation with Douglas Gimple.
Jessica Schmitt (0:58)
Hey Doug, great to have you back on the podcast.
Doug Gimple (1:01)
Great to be here as always. Thanks for having me back.
Jessica Schmitt (1:04)
Absolutely. Well, let's kick it off as we usually do, Doug, with an update on the latest comments from the FOMC committee and Chairman Jerome Powell. Their latest meeting was at the tail end of January, as we know, on the 30th and 31st, and of course, they held rates steady and maintained their target for the fed funds rate of five and a quarter to five and a half percent. Can you talk about the key takeaways from that meeting and then, of course, any updated insights you might want to share since then?
Doug Gimple (1:35)
Yeah, there weren't a lot of surprises at this meeting. No improvement on rates, no statement of economic projections or SEP as they call it, the dot plot as it's more widely known. Powell implied that they were most likely done with rates, but the timing of any cuts is yet to be determined. The various members of the FOMC that were making the rounds on TV prior to the blackout period, which is that week before the meeting where there's no communication from the Fed, laid the groundwork for Powell's comments providing a united front from the Fed.
The biggest takeaway was the slight shift from the markets themselves, adjusting the outlook for rate hikes in 2024. Before the meeting, fed fund futures were expecting close to six 25 basis point cuts by year-end with a 60% chance that the first cut would be in March. After the meeting in Powell's reinforcement of the idea that they were going to remain flexible to adjust to economic data, the chances of a rate cut in March dropped to 38%, but May was still showing essentially one rate cut and a 28% chance of two rate cuts. So, the market was still kind of well ahead of what the Fed was saying that they were going to do.
After the meeting in Powell's reinforcement of the idea that they were going to remain flexible to adjust to economic data, the chances of a rate cut in March dropped to 38%, but May was still showing essentially one rate cut and a 28% chance of two rate cuts. So, the market was still kind of well ahead of what the Fed was saying that they were going to do.
Most importantly, the longer-term outlook for 2024 from the markets was that there would still be close to six 25-basis point cuts before the year-end. But remember, the Fed was set on three 25-basis point cuts with no indication as to timing. I know we're going to dig into the Fed versus the markets in the next question, so I'm going to hold off on getting into much more detail.
Jessica Schmitt (3:15)
Yes, and actually that is the very topic of your monthly commentary, which for our listeners is available on our website at www.diamond-hill.com, and you can find that in our Insights section.
Doug, the title is “Don't Fight the Fed, Round II.” So, of course, we have a boxing match between the Fed and the market. This is one of my favorite topics because I find it such an interesting exploration of psychology. The Fed always seems to say very plainly, “Here's what we are going to do.”, and yet the market consistently seems to respond with, “Meh, we think you might do this.” So, help us understand what's going on here and maybe give us a little bit of backdrop and catch us up on the latest thinking in the market, especially now that we saw the latest inflation reading this week, which led equity markets down and bond yields higher.
Doug Gimple (4:15)
So I've been using the phrase, “Don't fight the Fed.” quite a bit over the last couple of years, but it certainly didn't originate with me. “Don't fight the Fed” is most often credited to the late Martin Zweig, which I hope I'm saying his name right, a well-known investment guru and television pundit who predicted the events of Black Monday back in 1987. So there's just a little bit of background. I didn't come up with that. It's been around for quite a while.
I added the “Round II” two phrase to the title because I believe round one occurred at the Jackson Hole Symposium all the way back in August of 2022. In an abbreviated eight minutes of speaking time, Fed Chair Powell was able to reaffirm the Fed's commitment to battling inflation and helped to pivot market expectations for that upcoming September meeting in 2022.
I interpreted some of his comments as essentially saying the market can price in whatever it likes to based on what it may believe is going to happen, but the Fed was basically saying, well, we're going to keep at it until we are confident the job is done.
As I tell clients and investors that I meet with, while the Fed definitely misstepped with the transitory inflation debacle, which I think they fully recognize, they've been nothing but resilient and determined to battle inflation and hold the course they originally plotted to bring inflation under control despite market expectations for the future path of rates.
Round II was a bit more subtle and was sparked by the market adjusting the Fed's outlook for the path of interest rates once again, fueled by what you mentioned, Jess, that stronger-than-expected inflation report earlier in February.
So, let's look back. At the end of 2023, as I mentioned earlier, fed fund futures were pricing in more than six 25-basis point cuts by year-end 2024, with the first cut expected in March, despite the ongoing Fed comments that it's going to be three by the end of 2024, and we just don't know when it's going to happen.
As I referenced earlier, there was a slight shift in expectations after that first meeting of the year in January, but there was still this significant disconnect between the markets and the Fed, with that six 25-basis point cuts still expected by year-end. So, the market shifted a little bit in the timing, but they were still pushing that idea for 150 basis points in cuts by year-end.
The turning point was the inflation report on February 13th, which showed that inflation had not cooled and, in fact, was a bit higher than expected. As you mentioned, this news generated a significant shift in the treasury market with rates pushing higher across the curve and the futures market. It felt like finally getting in line with the Fed's outlook.
After that inflation report, the futures market shifted the first rate cut to June and dropped the expectations for the full year down to essentially three-and-a-half 25-basis point cuts. But just this morning, the market still digesting Fed President Raphael Bostic's comments in which he stated that it's not yet clear inflation is headed sustainably towards the Fed's 2% target when the January producer price index was released. That index indicates the prices paid to US producers and it rose in January by more than forecast. So, yet another indication of the sticky nature of inflation. We're getting a firsthand look at the fact that inflation doesn't move in a straight line, and there are going to be bumps along the way.
As one would expect today, Treasury yields have once again backed up, equity markets are down and the futures market is reflecting some doubt that that first rate cut's even going to occur in June. So it feels like the market's slowly getting pulled back to what the Fed is expecting.
All of this noise in the market gets back to that original comment, don't fight the Fed. They have their plan, they've worded their comments so that they have the flexibility to adjust to economic news as needed, but the markets, for whatever reason, felt that there would be a significant move lower in rates. And I believe this is a case of the market getting way ahead of itself and expecting that since it appears the Fed is done with this tightening cycle, that rate cuts are right around the corner when the reality, and it seems like that reality is getting closer each day, is that we're going to be higher for longer. And technically that makes sense given the economic news that's coming out, and the Fed has that flexibility. And it's not to say that the Fed can predict the future or knows things that the rest of the market doesn't, but they dictate rates and they're not going to be cowed into doing the market’s bidding by getting ahead of themselves and cutting before they think it's absolutely necessary.
Jessica Schmitt (9:15)
And that takes us back to the “data-dependent” phrase that we've talked about for a long time.
Let's shift gears now into one of the market segments within fixed income that you touched on in the monthly commentary — commercial mortgage-backed securities or CMBS. This segment, as you pointed out, led performance within fixed income in January. Share with us a little bit about what drove that rally and what you're seeing in that market today now that, of course, we're in the back half of February.
Doug Gimple (9:46)
So, 2023 was definitely the year for investment-grade corporate debt. Relative to other areas of the market, spreads compressed dramatically over the final two months of the year. And there really was this giant rally November and December of last year and all sectors benefited, but really the move we saw was on the corporate side.
The CMBS sector was a laggard for the year on a relative basis, but it was still able to generate decent total return thanks to that year-end rally. The sector really stood out in the first month of this year, as spread tightening that the other sectors experienced carried over into the CMBS sector, albeit at a bit of a delay, so it really felt the impact in January. Fundamentals are still weak, delinquencies are increasing since the beginning of the year, and there's still that downgrade risk in certain areas of the market.
As an example, S&P downgraded four tranches of CMBS while DBRS placed a large number of deals on negative watch. So, there's still that concern about that part of the market, but the sector has benefited from the Fed's shift in tone, which really started in November of last year, that they're potentially done with tightening. I'm not going to say that they're done based on everything we just talked about and there's going to be easing sometime in the coming year, and we've got the prospect for CMBS of more favorable refinancing opportunities. The market was essentially pricing as if refinancing was going to be very challenging, but now that rates have stabilized and had come down, at least in the last two months of last year, we felt there was some stability there. And just as last year saw the entire segment of CMBS painted with this very broad and punishing brush.
So, have the positive aspects of January been felt industry-wide? Both instances provide opportunity for relative value investors. Essentially, strong securities that you can purchase that are now attractively priced due to that spread widening that we saw last year, or the opportunity to potentially sell weaker securities that have been carried along with this spread tightening that occurred in January. So really the movements of the last several months reflect the importance of security selection, strong due diligence, and really understanding what you own when selecting securities for inclusion in a diversified portfolio.
Jessica Schmitt (12:16)
Thanks, that's a helpful overview, and I'll just take a minute to mention to our listeners that you, Doug, will be hosting a webinar in late April with Wenting He, she's one of our fixed income analysts, and the two of you will be doing a deeper dive into the CMBS market. So, if this is an area of interest for our audience, just keep your eyes out for more details on that upcoming webinar.
Let's pivot now to the residential side of the mortgage market, Doug. What are we seeing in that area and are there opportunities to be had for fixed income investors in that market segment?
Doug Gimple (12:51)
For those that are familiar with our history and fixed income and our investment process, there's always been a focus on the residential mortgage market as we believe it's a fairly inefficient market that offers a lot of value for the amount of risk associated with it.
But during quantitative easing and zero interest rate policy, spreads in the RMBS market were incredibly tight and it was more challenging to find those opportunities. The combination of quantitative tightening when the Fed is passively reducing its balance sheet and interest rates climbing since 2022 has presented opportunity once more in the RMBS market.
Consider a mortgage pool that consists of 2% to 2.5% mortgages. The homeowner will most likely not consider any kind of refinancing and will also be very hesitant to move, which is that term of golden handcuffs, meaning that, sure, I'd love to sell my house, but if I sell my house, then I'm going to be getting a 6% mortgage or a 7% mortgage, and it's not palatable for homeowners.
These pools of 2% to 2.5% mortgages can price as if there will never be any kind of prepayment, which is a bit overdone because we know that there's a natural level of prepayment due to things like divorce, death, relocation, upsizing, downsizing. So, you can buy one of these pools at a discounted price, which again reflects that minimal prepayment aspect and ride that bond to par knowing that any kind of prepayment that you get from that natural prepayment that I just mentioned is going to be reinvested back into an environment with higher rates.
It's an area where we've continued to add over the last, I'll call it 9 to 12 months, where prior to 2022, we had been underweight that part of the market and now we've moved more to an overweight position. And I know we're not alone in that. A lot of managers have been doing that, but I think the way we approach it, it's a little different. We're not just allocating to the sector, we're buying CMOs or collateralized mortgage obligations, which are very specifically structured cash flows. So, it's a way to differentiate even as most of the market thinks that there's some opportunity on the residential mortgage side.
Jessica Schmitt (15:20)
Doug, maybe you could share too, outside of RMBS, any areas of the market that the fixed income team here at Diamond Hill are finding particularly interesting of late?
Doug Gimple (15:31)
Well, Jess, that's a pretty broad question, but from a high level, and hopefully this has been communicated as I've been talking, but I'd say we're much more constructive on the securitized side and I would say cautious on the corporate side. And it's not cautious in that we think anything credit event-wise is going to be happening in the corporate market in the foreseeable future. It's more that corporate spreads continue to grind tighter, and even though we've seen spread tightening in the securitized sectors, the relative value is much better compared to corporates.
So, an example, let's look at the ICE Bank of America benchmark indices, specifically AAA CMBS, so your highest quality commercial mortgages with, and we have to look at kind of a comparable duration to the corporate sector, and you're getting as much spread in AAA CMBS securities as you're getting in BBB corporate securities. So, the highest quality, and you're getting comparable spreads to the lowest quality in the investment grade corporate side.
And again, that's more a reflection of how tight things have gotten in the corporate space. And that's in the face of, I think it was $194 billion in issuance last month, another hot issuance market this month on the corporate side. So, a bunch of issuance and a bunch of interest. So that's continuing.
Within securitized, specifically to ABS, there's a bit of bifurcation. We're willing to dip into subprime areas of the market where there's hard collateral, so think autos and equipment. We're staying in the prime to near prime parts of the market when it comes to unsecured ABS, like credit card or consumer loans. Both areas of this market, because of their structure and part of the ABS sector, they have credit enhancements that are designed to protect investors. But that hard collateral of, again, autos, trucks or some kind of equipment adds another layer through recovery values if there is a delinquency, if there is a default. So, we're a bit more comfortable in the subprime part of these hard collateral markets.
Broadly speaking, we've brought the duration in our core strategy closer to neutral with the benchmark. Investors and listeners recall that we target plus or minus 10% of the benchmark’s duration. So, we want to be close because we know that we can't predict where rates are going to go, but we've brought the relative positioning closer to the benchmark as we do expect the Fed is nearing the end of the tightening cycle. I'm not going to sit here and say that they're done no matter what because there's always a chance, to paraphrase Dumb and Dumber. So, they're near it and we're poised to enter this easing cycle at some point. We just don't know when. And because we don't know when it's going to happen and to what degree and velocity at which it's going to occur, we're not going to rely on duration positioning to drive returns. So, it's sticking to what we've always done and a little bit of a shift with regards to duration, but still staying well within that band, getting a little bit closer to neutral. And that's just broadly when we look at our core strategy, which is the best way to get our thoughts on where rates are in looking at that duration.
Jessica Schmitt (18:58)
Well, great. Doug, as always, we appreciate your insights into the market. Thanks for joining us today.
Doug Gimple (19:05)
Of course. It's always my pleasure. I love talking about this stuff.
Jessica Schmitt (19:09)
Awesome. Well, we look forward to more updates with you throughout the course of the year, and I hope everyone listening enjoyed our conversation. We appreciate your time and interest, and we look forward to bringing you more on fixed income markets in the future.
Doug Gimple (19:23)
Thanks, Jess.
Jessica Schmitt (19:25)
Thanks, Doug.