Yield curveball

It’s a classic showdown in the late innings. Federal Reserve Chair Jerome Powell stands on the pitcher’s mound throwing heat. At bat is the market, which like the mighty Casey is ignoring the fastballs, thinking each will miss the plate.

This game is playing out in the Treasury yield curve, which reflects market expectations the Fed will ease rates as early as the fourth quarter. It’s a stance based on slipping inflation data and the recent shrinking magnitude of hikes. The latest downshift came with yesterday’s 25 basis-point fed funds increase that lifted the target range to 4.5-4.75%. But it dismisses the Fed’s resolve to subdue—not just lower—inflation. Powell reiterated this in his press conference following the FOMC meeting. While acknowledging disinflation in some parts of the economy, “we see ourselves as having a lot of work to do,” adding that he continues to worry about “doing too little and finding out later that you didn’t go far enough.” The FOMC statement reflected this, saying officials anticipate more hikes will be needed to establish restrictive policy.

Count us among those who question the assumption that inflation will continue to decline quickly. The robust labor market and resilient consumer suggests CPI could hover around 4% for a while. That will test the resolve of policymakers bent on avoiding a repeat of the ’70s. It’s important to remember they did not technically start tightening until July, when the target rate rose above 2%. Prior to that, they were simply normalizing monetary policy, pulling rates up from the ultra-accommodative zero bound.

We think they will stay higher for longer, maintaining a 5-5.25% range into 2024, a scenario Powell laid out as his base case. In a “read my lips” moment, he said it likely will not be appropriate to cut rates this year. Whether or not investors take him at his word, we are wary of longer-dated securities currently yielding less than what we think they should. The market has the choice to pay attention or whiff on a pitch the Fed said it would throw.

The situation portends continued support for the dash for cash. Investments into liquidity products historically garner inflows when rates stabilize after rising. That was the case in the tightening cycle of 2015-18, when industry money funds saw growth of around 11% (Investment Company Institute). After the Fed lowered rates in 2018, assets grew even more, showing a 14% increase. Past performance is no guarantee, of course, but if this trajectory is repeating, industry assets have grown ahead of schedule. Crane Data reports total money market fund assets hit an all-time high last month, rising $235 billion over the past 13 weeks to reach $4.82 trillion on Jan. 28.

Another financial showdown is taking place in Washington. The battle over raising the federal debt limit will be messy and embarrassing, but the “adults in the room,” as my colleague Susan Hill characterized them, will prevail over the politics of petulance to ensure the U.S. won’t default. While financial institutions and investors are better prepared for this than in 2011, we don’t think it will come down to the wire. Expect drama, not danger.

We continue to position our portfolios with short Weighted Average Maturities to take advantage of the hikes and keep ample liquidity. Our prime money funds target a 15-25 day range, with our government and municipal products at 25-35 days.