The decision to keep rates steady may hold the seeds of a hike in September, says Michael Greenberg
The US Federal Reserve’s decision to hold interest rates steady once again comes with the seeds of an interest rate hike baked in. That’s the view of Michael Greeneberg, senior vice president, portfolio manager, and head of Americas portfolio management for Franklin Templeton Investment Solutions. Greenberg sees in the three dissenting Governors arguing for a hike and Fed Chair Kevin Warsh’s comments about a “good family fight” the inklings of a signal that there could be an interest rate hike at the next Federal Open Markets Committee (FOMC) meeting in September.
“They were able to hold interest rates steady, which of course didn't upset the market at least all that much, while having a few dissenters, which just really opened the door to the idea that September is a very reasonable, possible time that they could raise interest rates,” Greenberg says. “Warsh was very focused and very direct when he said ‘we will deliver price stability.’”
Greenberg outlined what persistent inflation above the Fed’s two per cent target means for US fixed income assets broadly. He outlined the risks and opportunities introduced by new dynamics in credit market and high levels of government debt issuance as well. He emphasized, throughout, that diversification should help Canadian investors and their advisors, but that true diversification may lie beyond public fixed income markets.
A lack of Fed guidance and a market running on data
One of the dynamics that Warsh remarked on in his press conference following the announcement was a gradual rise in interest rates over the past month. He said that this move upwards in rates, without any published forward guidance from the Fed, could be evidence that markets are “playing the ball and not the referee.” Greenberg remarked that the Fed’s reticence under Warsh to publish forward guidance should coach markets into greater data-dependence, which can result in market-driven rate hikes without the Fed having to make a decision.
Greenberg notes that this dynamic of data-driven de-facto rate hikes can be challenging for markets in a stagflationary environment. However, he believes the Fed is happy to let this run because their focus is more on inflation risk than growth risk at the moment. The bias on the FOMC has moved, he says, when asked why we haven’t seen dovish dissenters to the decision the way we saw in the final meetings chaired by Jerome Powell.
While the Fed may be more tight-fisted with forecasting under Warsh, Greenberg doesn’t believe we’re returning to the days of Alan Greenspan’s chairmanship, when rate hikes might occur silently in the middle of the night. Fed leaders will still speak to media and even naming the dissenters, as was done with this decision, gives analysts some insight into where the Fed might go next.
What to expect from US fixed income now
Another dynamic in the US economy and US fixed income markets that Warsh remarked on was the ongoing capital expenditures by large technology companies in the US. This capex boom aimed at building data centres and AI infrastructure, is now being financed by large debt issuances on the part of major US tech firms. All that influx of corporate debt, along with continued bond issuances by the US government as its debt ratchets higher, should result in lower overall bond prices and higher interest rates. However, Greenberg also notes that we don’t actually know how much debt the market can digest. The dynamic, he says, is likely one of higher overall interest rates as well as higher rate volatility.
Higher resting interest rates, especially at the long end of the curve, should be helpful for investors seeking insurance against slower economic growth. However, he notes that if we see another stagflationary shock like the one that occurred in 2022, there could be a return to positive stock and bond correlations which Greenberg says may be better navigated by allocations to private assets than to fixed income.
Greenberg believes there are also some risks in credit markets now, despite the attractiveness of higher yields, as excess yield spreads relative to government bonds remain tight and more AI-related debt gets issued. He cautions advisors to look at the amount of exposure to the AI theme they may be adding to client portfolios through credit exposures, given the heavy weights they may already hold in any US equity exposures.
While inflation risks are an area Greenberg remains aware of, he notes that Franklin Templeton’s base case is not a return to the 1970s. He’s comfortable with holding some longer duration bonds as a growth protector, acknowledging that they come with more volatility than they may have had in the past. When that volatility comes, Greenberg stresses that advisors have the responsibility to control for any overreactions.
“It comes back to those first principles. Obviously you want to be aware of what's going on in the world but, but don’t overreact to any one piece of news and just stick to that investment plan that's just shown time and time again that long term thinking tends to outweigh the short-term market timer,” Greenberg says. “I think these types of environments just reinforce that.”
