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TCW is a leading global asset management firm with over 50 years of investment experience and a broad range of products across fixed income, equities, emerging markets, and alternative investments. In each episode of TCW Investment Perspectives, professionals from the firm share their insights on global trends and events impacting markets and the investment landscape.
Hello everyone.
Thank you for joining us for the TCW Investment Perspectives Podcast.
My name is David Vick.
I'm a product specialist here in the Fixed Income Group at TCW.
Joining me is Jamie Patton, co-head of Global
Rates and specialist portfolio manager.
Jamie, thanks for joining me.
Thanks so much for having me.
Sure.
We're here to talk today a little bit about the Fed and
inflation and what's happening in the world of interest rates.
So, we'll start with a couple of questions and see where we go.
Great.
So, the June CPI report came in a little below expectations.
Softest reading we've seen in a while.
Clearly, the trend seems to be lower in terms of inflation.
What's the outlook there?
Are we past the worst of it?
Is it going to get better?
Where are we going as far as inflation goes?
Well, we think the Fed will certainly welcome the progress that we saw in the
June CPI report, particularly the softening in the super core inflation measure.
And what I mean when I say that is the core services x rents.
That was flat in June, which was the lowest reading since September 2021.
But CPI at 3% last month, even though it's one third of
the level it was a year ago, which was the highest in
four decades, we're still not at the Fed's target of 2%.
And the Fed has been really clear that its job is not done.
It's not game over.
So we and the market still think the Fed will raise
rates by 25 basis points at their next meeting in July.
And July could be their last hike, but we also see maybe a 30% or 40%
chance, almost a coin flip, that the Fed would have to go one more
time, just depending on how the data comes in between now and then.
So great progress, but we still have some work to do.
As you mentioned, the Fed seems to have at least one, maybe two
more hikes on the docket, but they seem to talk very aggressively.
They seem to talk like they've got more wood to chop, they've got more to do.
How do you reconcile those two between what they're
saying and what they might actually have to do?
We take that to mean that the Fed is happy with their
progress, that inflation is coming down, but it's not enough.
And they want the market and market participants and the
world to know that they are very committed to bringing
inflation all the way back down to their 2% target.
And progress doesn't mean success.
They still have more to go.
And I think they want to be really clear about that.
Got it.
So, you know, we talk a lot about, you know, monetary policy lags.
They work with lags.
They're long and variable, as was famously said.
And the hiking just started really five quarters ago.
I've heard good arguments that the lag should be longer
this time and some that it should be shorter this time.
What do you think about how long it takes for those, the
impacts of hikes to really be felt in the broader economy?
That's a great question and something we talk a lot about.
It's really hard to predict exactly when policy moves will slow
demand in an economy that's rapidly changing, very complex.
So predicting that timing and when that will
reduce inflation pressures is really hard.
We know it happens gradually.
Many think of a rule of thumb as 12 to 24 months.
And you might wonder, why does it take so long?
What can make it go faster?
What can make it go longer?
The bottom line is that it takes businesses and consumers
time to recognize, let alone really feel the impact and
change their behavior based on financial conditions.
For example, if you built a factory in 2020 and you locked in
your financing, these higher rates are of no impact to you.
And it's really not until you go to build the second factory or
refinance that all of a sudden you might change your behavior.
Maybe you don't even build that second
factory if rates have made it less economic.
But then mortgage rates, on the other hand, if you're looking to buy a
house right now and mortgage rates have risen 100 basis points, your
budget for how much house you can buy may have changed almost instantly.
There was actually a speech recently by Fed Governor Waller discussing
these monetary policy lags that really got our attention because
he makes the case for shorter policy lags than historically.
And popular opinion recently has been that lags are actually longer.
The reason for longer would be the Fed has an $8.5 trillion balance
sheet right now, whereas it used to be more like $1 trillion.
So that's really cushioning the blow of higher interest rates.
The argument that Waller made was actually that the forward guidance
of the Fed could shorten the lag, meaning it gets priced in.
The Fed tells you where rates are going to be
and it gets priced in to markets right away.
Now, we're not academics.
We're trying to make the most possible money for our clients.
So it doesn't really matter to us what the right answer is.
What matters to us from the Waller discussion was that he's suggesting if
the lags are short and the economy has already felt the 500 basis points
of Fed hikes, he's implying that the Fed needs
to go higher and keep rates higher for longer.
And if the consensus of FOMC participants share that perspective, which is
actually something the June dot plot suggests with the median dot being
another 50 basis points of hikes, then the stance of monetary policy
may be kept overly restrictive for a long time, maybe even too long.
And that raises the risks of larger than expected declines
in growth and inflation, maybe a bigger recession.
And it supports our positioning at TCW being long duration.
Great.
So we talk about higher rates.
Obviously, last year, we saw rates move dramatically higher, which
was painful for investors sort of across the capital markets.
Are there any benefits to rates being this high
or further rate increases that we see from here?
For sure.
Higher rates are definitely not all bad.
They of course hurt borrowers, but they help savers.
And the net impact depends on the offsetting impacts to each group.
For example, today's savers, even if they're just in money market funds
or treasury bills, they're earning over 5 percent per year, which is the
highest rate in more than two decades and well above current inflation.
The yields on TCW bond funds also reflect a
benefit to savers much higher than historically.
That said, if you go to get a mortgage right now, really painful.
For sure.
So we've seen markets, rates in particular, lots of
volatility over the last six months, even the last 18 months.
What's your expectations for volatility going forward?
And once the Fed sort of gets past this hiking cycle,
should we expect to see volatility come down some?
Yes.
Volatility in the end should come down, but it makes
sense to us that volatility is so high right now.
The Fed is not debating just one thing.
Do we hike 25 basis points or not?
They're debating further hikes.
They're debating pausing.
They're debating whether to cut rates and when to cut rates.
So at this late stage of the Fed cycle, when markets could
go in any direction, not just, not even three, there's
more than three directions the markets could go.
It makes sense to us that vols might be so high.
It's reflecting the actual implied volatility of the market.
And our own view is that the Fed will deliver one
more hike with a lower chance of a second hike.
But the nature of policy paths and how many different
paths there are, are probably going to keep vols elevated
until we get some clarity around the end of the cycle.
Got it.
So you hinted at it there at the last couple of comments there.
So what's the view on what the Fed does from here?
And how does that drive portfolio position, broadly speaking, across strategies?
So our view, again, is just one more Fed hike
and then 30% or 40% chance of another Fed hike.
We kind of think of it as 50/50, depending on how the data comes in.
We expect monetary policy to continue to be the big driver for rates and
the economy going forward, especially at this far along in the cycle.
Our view at TCW is that the Fed is likely to over-tighten, or they may
have already over-tightened, and keep rates too high for too long.
One reason for that is that their gauges of inflation
pressures tend to be the most lagging indicators.
Higher rates and flatter or inverted curves, as the case might
be, negatively impact investment, consumption, employment.
We think that all leads to a negative self-reinforcing downturn.
And tighter credit conditions on top of it all could exacerbate that downturn.
As a result, we remain long duration, roughly
a half of a year longer than our benchmark.
And as we approach the end of the Fed tightening cycle, we think the economy is
likely to enter a recession at some point over the next six months to one year.
Any thoughts on when the Fed might ease?
And under what conditions might they do that?
Like, where does inflation have to be for them
to feel comfortable cutting rates finally?
The Fed has told us they need to see inflation at its 2% target.
Now there's a lot of wondering in the markets if the
Fed might be OK with inflation a little bit higher.
They talk about average inflation.
It's been so low for so long.
Now it can be a little bit higher and average around 2.
But what the Fed has told us, if we just listen to the Fed and trust them,
is that their number one overriding goal is to bring inflation down.
They would love to do that without triggering a recession,
but they are absolutely not afraid to trigger a recession.
And they've been clear that they'll err on the side of
bringing inflation down at the cost of a recession.
Once inflation is back at their target, they'll want to be at a neutral rate.
We roughly think that rate is somewhere around 2.5%, which is where
their long run dot is or their projected target rate over the long run.
Between now and then, when they are very confident that inflation is
approaching their target, they'll likely begin to lower the policy
rate from this very restrictive level back towards the neutral rate.
Market expectations are for the Fed rates to peak this fall and then
start coming down towards the end of Q1 or the beginning of Q2 next year.
We think there's a risk the market is pricing in cuts too soon.
It could take longer, mostly because of that
longer lag that we talked about earlier.
And then there's also a risk that something breaks in
the meantime and the Fed has to lower rates prior.
So we see risks to both sides.
But we do think that monetary policy is the big driver.
We're really focused on that.
And because the Fed is likely to keep rates so high for so
long, that's why we're in these long duration positions.
Great.
All right.
Well, thanks very much.
Sounds like there's some potentially some tough sledding ahead,
but opportunities down the road once the Fed does finally decide
to decide they need to ease once inflation is a little lower.
Thanks very much, Jamie.
Thanks for joining us.
Thanks so much for having me.
Great.
Thanks very much, everyone.
We'll see you next time.
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