{"id":1172,"date":"2023-11-21T20:10:56","date_gmt":"2023-11-21T20:10:56","guid":{"rendered":"https:\/\/www.amerantbank.com\/ofinterest\/?p=1172"},"modified":"2023-12-01T15:49:19","modified_gmt":"2023-12-01T15:49:19","slug":"avoiding-the-cash-trap","status":"publish","type":"post","link":"https:\/\/www.amerantbank.com\/ofinterest\/avoiding-the-cash-trap\/","title":{"rendered":"Fixed Income in Focus: Avoiding the Cash Trap"},"content":{"rendered":"\n

The most frequent question we get asked these days is, \u201cIs the Fed done?\u201d While we are of the view that the Fed is likely done hiking, whether we are right or wrong hardly matters. What does matter is that rates are as high as they have been in a generation across the entire yield curve<\/em>, and we think client should focus on the longer term yields on offer, rather than focusing on whether the Fed will raise rates by another +25 bps or so.<\/p>\n\n\n

\n
\"\"<\/figure>\n<\/div>\n\n\n

As a reminder, the Fed began its aggressive rate hiking campaign in a generation last March. In the past 18 months, the Fed funds rate has climbed from zero to a range of 5.25% to 5.50%. The most recent hike was in July, and the Fed has kept rates steady at the last two meetings.<\/p>\n\n\n\n

As of this writing, markets are pricing in a 90% chance of steady rates at the December FOMC. If that comes to pass, the Fed will have been on hold for three consecutive meetings, with the last rate hike coming in July 2023.  We think it becomes much harder for the Fed to restart rate hikes after such an extended pause, unless there is clear evidence that inflation \u201cgenie\u201d has not been put back in the bottle.<\/p>\n\n\n

\n
\"\"<\/figure>\n<\/div>\n\n\n

Inflation Genie: Mostly Back In the Bottle<\/strong><\/h2>\n\n\n\n

The reason for the Fed\u2019s aggressiveness is the rise of inflation. Headline CPI rose to a peak of 9.1% in June 2022 following pandemic supply chain challenges and higher oil prices following the war in Ukraine. Since then, the Fed\u2019s top priority has been to get that number back down towards its policy target of 2%. We note that the Fed actually targets core PCE, not headline CPI. The peak for core PCE was 5.5% in mid-2022; still too high, but not as far away from target as widely believed. Since last summer, inflation metrics have continued to fall. For September, both headline CPI and core PCE were 3.7% on a year-over-year basis.<\/p>\n\n\n

\n
\"\"<\/figure>\n<\/div>\n\n\n

Although we\u2019re not all the way back to 2% target, we are much closer and the trend remains in the right direction. The Fed has not committed to a particular date for achieving its 2% inflation target, and we think that is deliberate. The Summary of Economic Projections shows that FOMC members expect core PCE to approach 2% only in 2025, nearly two years from now. The Fed is attempting to pull off a \u201csoft landing\u201d in which inflation retreats back to the target range, but without causing a recession. If inflation does not fall as expected, we can\u2019t rule out that there could be one more rate hike in the cards.<\/p>\n\n\n\n

It Doesn\u2019t Matter<\/strong><\/h2>\n\n\n\n

Nevertheless, we would argue that whether the Fed is totally done hiking rates is not all that important. Rather, we think the question should be: Are rates going to rise much<\/em> higher<\/em> from here? Is there a high probability that the Fed has long way still to go? With the Fed funds rate at 5.5%, is there a reasonable chance we could see the Fed funds rate at 6%? 7%? 8%?<\/p>\n\n\n\n

In our view, the answer is clearly No. The focus over whether the Fed might do one more +25 bps hike or not, or even two more, is less relevant that the broader takeaway: the Fed is now very close to ending this hiking cycle. We have already begun to see inflation falling, labor markets cooling, and the overall economic outlook coming off the boil.<\/p>\n\n\n

\n
\"\"<\/figure>\n<\/div>\n\n\n

Importantly, we believe investors should take heed of the what the yield curve is saying. The yield curve has been inverted since mid-2022, and it remains inverted across multiple metrics: 3M vs. 1Y, 2Y vs. 10Y, 3M vs 18 forward 3M, which is the Fed\u2019s favorite. We emphasize the inversion itself <\/em>indicates markets think interest rates will be lower in the future. Because of bond math, a longer-term interest rate can be thought of as a series of short-term rates, that are reinvested in the future, plus a \u201cterm premium\u201d for the uncertainty of rates will be at the reinvestment points. The fact that the yield curve remains inverted tells you that rates are likely to decline in the future, otherwise bondholders would demand higher yields for holding longer bonds.<\/p>\n\n\n\n

Is Cash a Trap?<\/strong><\/h2>\n\n\n\n

What does all this mean for investing right now? We have seen various pundits arguing that cash is essentially a \u201ctrap\u201d at current levels. On this point, we heartily agree.<\/p>\n\n\n\n

A historical analysis by JPMorgan reviewed subsequent returns for Treasuries and all bonds (represented by the U.S. Aggregate bond index) over two year periods following the yield curve inversions since 1981.<\/p>\n\n\n

\n
\"\"<\/figure>\n<\/div>\n\n\n

In every instance, Treasuries and bonds outperformed cash returns in the following two years. The reason is simple: as rates fall, cash and cash equivalents, such as money market funds, reprice downward immediately.  In sum, that 5% rate clients see today on their T-bill or money fund is basically an illusion. In two years from now, rates in the U.S. are likely to be lower. Clients who didn\u2019t extend duration may have lost the chance to lock in higher rates for longer.  We advocate that clients with an appropriate investment horizon add duration to their fixed income portfolios now, in order to avoid falling into the \u201ccash trap.\u201d<\/p>\n\n\n

\n
\"\"<\/figure>\n<\/div>\n\n\n

Source: https:\/\/filmschoolrejects.com\/its-a-trap-meme\/<\/em><\/p>\n\n\n\n

Definitions, sources, and disclaimers<\/p>\n\n\n\n

Definitions<\/u><\/strong>:<\/strong><\/h2>\n\n\n\n