First Trust ROI Podcast
On the ROI podcast, we discuss some of the most important questions facing investment professionals today, ranging from macroeconomic views, to perspectives on the equity and fixed income markets, to insights on practice management. We aim to cut through the noise, examine the data, and provide fresh insights to investment professionals as they help their clients find better ways to invest…seeking to generate attractive returns on their investments.
First Trust ROI Podcast
Ep 31 - Bill Housey - Why Have Longer-Term Interest Rates Increased Since the Fed Began Cutting Rates? - ROI Podcast
Bill Housey discusses recent dynamics in the bond market, including why longer-term interest rates have increased since the Fed began cutting rates, where we are in the economic cycle, and implications for fixed income investors.
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Hi, welcome to this episode of the First Trust ROI podcast. I'm Ryan Isakainen, etf strategist at First Trust. In today's episode, I'm joined by Bill Howsey, managing Director of Fixed Income at First Trust. Bill and I are going to talk about what has happened with interest rates since the Fed cut by 50 basis points. We're going to talk about the economy and where we see opportunity in the bond market. Thanks for joining us on this episode of First Trust ROI Podcast. Bill, thanks again for joining us on the podcast. I think this is your third appearance on the podcast. You were my second guest ever, so I appreciate you sticking with us. A lot going on in the bond market Always Great to be back. So I was thinking as I was on my way heading into the office today what would Bill Howsey be doing if he was not a star bond manager? And that's my first question for you If somehow you didn't end up in the financial industry as a bond manager, what would you be doing? What would I be doing if?
Bill:not managing bonds. Well, my interests are in barbecue. Right, it would be brisket. It would be really good barbecue, authentic barbecue. You know, that's where I find you know my sort of labor of love, if you will.
Ryan:Yeah, you'd be a pit master, I'd be a pit master, nice, there's nothing like a good barbecue, especially like a brisket, if you get it right. You know, do you do kind of like the six-hour thing, the three-two-one method or what's your preference?
Bill:I have ruined a good number of briskets in my day right and. I've rushed them. I've I've, you know, found lots of different techniques and tactics. My favorite way to do it as an overnight smoke, so you smoke it overnight while you sleep, yeah, and then you wake up and you got to get it to the perfect temperature.
Ryan:Okay. So what I learned making a number of briskets and getting some wrong, getting some right is, when I'm that first stage, I take some of the fat the drippings, make tallow with it, oh yeah. And then, after you wrap it with your butcher paper, you put a little of that on the paper and it keeps it nice and moist during the rest Perfect. I don't want to give away all the tips, but Okay, all right. So back to business here.
Ryan:Bill, the Fed is what's in the news. Over the last few weeks, finally, after a cycle of raising, the Fed decided to cut rates by 50 basis points. I think one of the surprises for many people in the market was that the longer end of the yield curve since then has actually seen about a 40 basis point increase at the 10-year. So I guess that's my first question for you. Was that a surprise to you that you'd see the curve steepen, at least between the federal funds rate and the longer end of the yield curve, in the wake of what the Fed did, and what are the implications of that?
Bill:The real driver of what we've seen to shift those interest rates higher has been more about the expected number of cuts that were in the curve. We look at the minutes that came from that meeting. It wasn't a one-sided view. There was clearly some heavy discussion around that topic. But what really came after that were market expectations that we were going to see not only those 50 base points of cuts that came through in the middle of September, but as many as eight more cuts by the end of next year. And our thinking on that was that there's just too many cuts priced into the curve based on what we know today with respect to the economy, the labor market, inflation data, Not to say that that destination doesn't make sense, meaning a terminal Fed funds rate of around 3% at some point in the cycle. Principally because if we're back to a 2% inflation target at some point, a 1% real rate, a real federal funds rate so a terminal rate at 3%, inflation at 2%, gives you a 1% real rate.
Bill:So what's actually occurred? We had that big labor market print beat in non-farm last week and what's really resulted is that some of those extra cuts that were priced into the curve have now been removed. So that's what's brought rates back up. The only thing that's really transpired is we've taken some of those cuts and we've kicked them out. So now, if you were to look at the expected Fed funds rate over the next, you know, into the end of December 2025, there's about six cuts priced in, and what we would say is that looks a lot more reasonable to us. So that's how I would come back to what's occurred with respect to rates.
Ryan:I want to stay in the economy for a minute, partly because the yield curve normalized in light of the Fed's cutting rates and it's been normalized now since then, I believe. Maybe it went a little bit negative at one point, but historically that has often preceded recessions and there's a lot that's different in this cycle and we don't have to review all those differences. But in your view, is this time different? Is it not going to precede a recession soon after the yield curve normalizes, or is that what we would expect to happen again?
Bill:Empirically, as we look back at the you know last several business cycles, a lot of people tend to look at the inversion of the curve as a warning sign for the business cycle. But in fact, the point that you're making is that it's the un-inversion that's typically much closer to the end of the business cycle, the data, as we were just talking about, that we get in the business cycle and the economy is incredibly lagging. And one of the best anecdotes I have for this is you can go back to you know the financial crisis and you know the yield curve inverted in 2006,. Right, we obviously didn't get a recession until December 2007. It was a very long period between that inversion and the ultimate recession. But the anecdote lies in then-Chairman Ben Bernanke's comments, where he had said the Fed had engineered a soft landing and by October 2007, the S&P put in a new high and I'm sure he was feeling really good about the soft landing at that point. And, of course, by December 2007, we were in a recession. But it was even better than that because it was either January, february 2008,.
Bill:Chairman Ben Bernanke is giving a speech and he's asked does the Fed foresee a recession? And his reaction or response was no, the Fed does not foresee a recession. We were already in the recession and these are really intelligent people. So it isn't to say that intellect has anything to do with this. It's just that the data is so incredibly lagging. And so you know the point about. Does the un-inversion signal a late cycle indicator? It has in many cycles. You know, forecasting a recession is very difficult, timing a recession practically impossible. You may as well put the tarot cards on the table and we'll do our best with that.
Ryan:So would you say that there's more of a bias, that the likelihood or the probability of a recession is greater now that the yield curve has done what it's done?
Bill:I would say that it's a good late cycle indicator, but it's one of many. I do think that it's telling us that we are later cycle, because what it really ties back to, in my mind at least, is that the Fed is reacting. Let's remember what the Fed's job is. It's a dual mandate. It's employment and inflation that they focus on. Now, for the last couple of years it's been a single mandate. It's been inflation, inflation, inflation right.
Bill:What did the Fed do? The Fed raised the equivalent of 21 times. The Fed raised the equivalent of 21 times 21,. 25 basis point hikes were injected into the economy.
Bill:Now there's a lot of debate about the transmission mechanism of that Fed policy. A lot of people locked in low mortgage rates and things like that, so maybe to that extent, the transmission mechanism isn't as great. Companies locked in low bond rates during 2020, 2021, when rates were very low. But the reality is that 21 rate hikes into the economy will have some effect at some point. And so the logic that it has no effect and perhaps it's mitigated in this cycle by the large fiscal impulse that came into the business cycle post COVID, I think we certainly think about that.
Bill:There's no mathematical model. At least that we have that ties it all together in a perfect bowl like that. But these are considerations we make. I just think that it's one of many variables we consider. With respect to that late cycle indicator, I do believe that the Fed is using lagging information because we know empirically we can look back at the last 60 years of business cycles and see that when unemployment is typically going higher, you're very late in the business cycle. When inflation is back to the Fed's target, you're typically very late in the business cycle in or around a recession. Does that mean we're going to tip over in a recession tomorrow? Of course not. It just means that these are all aligning with respect to the business cycle overall and in terms of late cycle indicators.
Ryan:Yeah, that makes sense. So this has been a weird cycle too. Right, it's been an unusual cycle, and I think there's been a lot of surprises for economists, for portfolio managers, for strategists. As you think about this particular cycle, is there anything that jumps out at you that has surprised you the most, either for the good or for the bad?
Bill:positive, negative there was certainly no textbook on investing through a pandemic.
Bill:When the government shuts down, the business cycle shuts down, the economy injects trillions of dollars. I mean, there were a number of unique circumstances that played through here and I think you know these are the things that we have to be thinking about where we could be wrong. Could it be that, for example, that large fiscal that's held up construction employment in this business cycle far better and far longer, despite the rising rates? I mean, certainly, if you just think about previous cycles, rising rates would lead to weaker demand for housing, lower housing prices and loss of construction jobs, but we had this big fiscal impulse that supported construction jobs. We had a dearth of supply because people had such low mortgages they didn't want to sell homes, so it led to higher prices.
Bill:So when you've been doing this through multiple cycles, you see that each cycle is unique and what we have to do is look at all the data the best that we can in an attempt to try to test our thinking with the data right. So we try to avoid just creating an opinion as opposed to relying on data. So we're always looking at the math, we're always looking at the data to drive the decisions, and I think that that's a really important thing that we have to do to test our thinking.
Ryan:So all that fiscal spending, all that money that was passed into laws there's still a lot of that that is authorized to be spent over the next couple of years and that has to be having an effect on a lot of the economy. So I mean, does that figure into your thinking? Is part one of the question, and part two is that has to be paid for and we're running huge deficits and deficits are projected as far as the eye can see. So what does that mean for interest rates looking forward?
Bill:It's a really good question, so let's break it down. There are definitely pockets of the economy that are feeling more pressure than others. I think wealthy consumers feel really wealthy in their spending. I think weaker consumers are under a lot of pressure right now, particularly with respect to what's going on with interest rate policies, and I think that's partially why the Fed is cutting right. It's one of the many reasons they are looking at the real rate in the economy as being punitive, especially for weaker consumers. Right, the real rate Remember they raised 21 times for 9%, inflation for 8%, for 2%, so we're at whatever 2.4% as of today. So you start to think about that. That's it becomes. That real rate becomes punitive for people, and I think that's what you're seeing now. As you bridge that then to the deficits.
Bill:With respect to the fiscal, the way I've thought about this is and Bob Stein, our deputy chief economist, has said it best. He said it's the most reckless spending in the history of our country. Right, we're not at war, we're not in a recession, and we're spending as though we are, so it's incredibly reckless. What I would say, though, is that the bond market has clearly coalesced around. An understanding of this is what the deficit is and this is what bonds will be needed to fund that deficit, and has sort of said this is the type of bond market pricing that's necessary to clear that deficit as we know it today. And I want to really emphasize that as we know it today, meaning if there's a new administration and they take the deficits from $2 trillion to $4 trillion, well that's clearly not in the price, right? I've used this old analogy. If you're old enough to remember the old Prego pasta commercials, they'd say it's in there, right, the ingredients in the sauce, right. And so when I look at the bond pricing of those deficits what we understand them to be today, I would say it's in there, it's in the price.
Bill:And the reason I say that, and the reason I say that the bond vigilantes haven't come yet, is because the bond market is trading on what the Fed is doing. The bond market is trading on the economic data. It's not decoupling from that. The auctions have been clearing. So if you look at the data, you look at the evidence, you would make the case that very clearly, the bond market isn't, the vigilantes aren't there. Now, if we get a new administration or there's a major policy change and we're going to uptier the spend. Well, clearly that's not in there and that would be damaging and you would clearly see the vigilantes coming out in that environment in our view. So we're not trading that today because I don't think you can trade that. It's very speculative in that sense. But that's how we're thinking about that?
Ryan:Yeah, so that would imply, when you say the bond vigilantes would come out. Just for those who don't know who these bond vigilantes are, that would imply higher interest rates, right, because they would demand that in order to actually have demand for that debt.
Bill:The bond market, investors would say I need to be compensated for this risk of heavier funding. Now, compensated for this risk of heavier funding. Now you know, if you look at growth in the economy 3% a year, that type of growth, 2% to 3% a year could the US government fund a trillion dollar deficit, have a trillion dollar deficit into perpetuity? Sure it could, right, Just based on the size of the economy. Does that mean it's responsible? No, it's irresponsible, right, and we see it clearly that way. But is it at such a point where the bond market is extracting a pound of flesh for it? Not yet, but if there is a major change, I think we would see that.
Ryan:The other thing I wanted to ask about with respect to inflation you brought up inflation a minute ago is how tariff policies you think would impact inflation. You know, of course you put a tax on, it's passed along to somebody and it seems like a bipartisan agreement that tariffs are. Now, you know, maybe we're getting a little bit more trade protectionism in our overall policy from both sides. Maybe we're getting a little bit more trade protectionism in our overall policy from both sides. It's interesting that none of the Trump tariffs on China were actually rescinded by the Biden administration and even more were put on. So it's not necessarily a political discussion about who wins the election. It seems like both are going to have tariffs. So my question for you is, as a bond manager, as you think about the impact on inflation and therefore rates, potentially, how do you think about tariffs?
Bill:There's a number of ways to take that conversation, but I think the best place to start is to go back to 2019, trump's tariffs come through. You go back to what occurred in 2019. Former President Trump's a markets guy, like if he puts a policy out there and the stock market starts to crater. President Trump I think President Trump's a markets guy, like if he puts a policy out there and the stock market starts to crater. President Trump I think he's a negotiator. He would look at that and likely say, hey, the market isn't digesting this the way I thought it should or would. But, more importantly, the narrative around tariffs is that you push tariffs through, prices go, surge higher and there's no doubt about it. We've looked at the data. We know the data that when you push tariffs through, it is inflationary. But it is a one-time inflationary thing, right? You don't. If you raise, if you put a tariff in place and you assume prices increase to offset that tariff, it happens. It's, they're recovered and it doesn't go up every single year, unless the tariff is changing every single year, right? Yeah, the other thing is that there's a presumption in most of what I've seen that's written about tariffs that when you have a tariff, a company immediately takes the price higher and offsets the tariff through that higher price. That's not what we saw in 2019, right, what we saw in 2019 was companies attempting to take the price higher but unfortunately unable to take the price to fully offset the tariff, and profits actually would come under pressure. And many companies look to react to move production, to find ways to mitigate the tariff. And so I don't believe it's as linear or black and white as the narrative would have one believe.
Bill:I think that if you had a significant or sizable tariff come into the market, you would likely have profits coming under pressure. I mean, we're back into a mid two and a half type percent inflation environment. The idea that the consumer will just willingly bear the brunt of a full tariff, I think, is a real stretch in my opinion. I think that some portion of that would be borne by the companies through profits, lower margins, if you will. I think some portion of that would be borne by the consumer over a period of time, but it's a one-time effect. Now I do think it still would show up in inflation. But the question is, you know, is it perpetual inflation? Because you put implemented the tariff, and my thinking, at least on this would be it would be temporary, because you would push it through and it's not an ongoing escalation right. It's a one-time type tariff that gets implemented and then exists.
Ryan:So it seems like part of the incentive for adding tariffs would be to maybe have some re-industrialization, some shifting manufacturing back to the states or at least back to some place where there was no tariff in place. And would that be part of your thinking with that as well?
Bill:Absolutely. I mean that's one of the main premises of the, you would imagine, of the policy right. Shift production back and create jobs domestically. Those are clearly drivers. Also create a revenue source back to the US from those tariffs, from the businesses that are producing elsewhere, for example. I think those are all parts of the policy discussion.
Ryan:Yeah, okay. So if you're a financial advisor watching the podcast and are listening to the podcast and you're thinking about how to position from a duration perspective, what would you say to that?
Bill:Today, as we sit here around 4%, slightly above 4%, with a realistic sort of expectations for the Fed cutting cycle that's underway. When we look at that, we're back to an environment where stocks and bonds are not behaving in a way that they're correlated anymore. The old traditional reaction function is seemingly back in place, where bonds are offering some protection against stock volatility. I think that's a very important consideration, and so for us, ultimately, I don't think that we have to be interest rate strategists anymore. I think we're in an environment where you can own the bond market, and when I think about the bond market, the duration of the bond market, which is your interest rate sensitivity, lives around six years for the bond market. So when we look at the Bloomberg Aggregate Index, which is inclusive of treasuries, corporates, securitized debt, core, fixed income right, that duration is around six years.
Bill:I don't think investors realize what their reinvestment risk looks like today. They've ridden these really short-term rates at a very high level now for a nice period of time, but I think, as we look forward over the next 12 months and perhaps we are a later cycle we do believe that the Fed is going to continue to cut. We're expecting as many as six cuts by the end of 2025. If you really sit there in ultra-short investments, you're just going to ride that yield down in most traditional forms. Of course, there's different ways bond fund managers, active managers try to mitigate that risk, but in the traditional sense, the way most investors are sitting in I think the last number I saw was close to $6.5 trillion in money market accounts they're not positioned in a way that they would be mitigating some of that reinvestment risk. So the way we've thought about it is owning a duration where the bond market is of around six years seems like a very reasonable set of you know sort of investment policy decision to have today.
Ryan:Are there any specific sectors of the bond market that you think are particularly attractive?
Bill:There's really not an always or never in my mind when it comes to the bond market. What we try to do is we look across different sectors and we say where's the value? These are a lot of relative value trades that are taking place. So even in pockets of the market that we may not love, we still find value in different corners of that market. Pockets of the market that we may not love, we still find value in different corners of that market.
Bill:I would say for most investors today, whether it's in taxable or tax-free, given where interest rates are, there's no reason to chase a lot of risk because you can earn a really attractive level of income in the bond market that you haven't had in a very long period of time, in our country at least and you can do it with relatively safe fixed income. So when we look at core fixed income things like whether it's corporates or securitized debt and even Treasuries as a safe haven, for example I mean you could really construct a nice portfolio and even in municipal bonds with tax-free, high quality, a really nice durable set of bond portfolios that you can create without taking a lot of excessive risk, and I think that's really important Now in the riskier pockets of the bond market. Things like high yield, for example, or even senior loans, those types of ideas, those can make sense. But I think those make more sense today in an equity bucket, meaning I can de-risk equity exposure by using some of those opportunities where there's still a compelling equity-like return that's capable of coming out of some of those pockets. So I think you can really bifurcate the market into safe and risk and really use your bond money for safer fixed income and look to use that duration not to swing for the fences.
Bill:I often tell people they say, hey, should I buy this really long duration? That's like buying a small cap stock. Right, you're picking a very specific point on the yield curve. You're hoping for a very specific outcome to make money in that point of the curve. What we're saying is you can own the bond market today and you can reduce your reinvestment risk by doing that or making sure you're with a manager that's working actively to do that.
Ryan:So you're an active manager and you mentioned considering high yield or some of the below investment grade as an equity substitute in an asset allocation. When it comes to those, specifically those parts of the bond market, but also, I think, probably corporate and the other the other sectors as well, municipals Managing risk is really important, right? So, as an active manager, what are some of the most important levers that you pull as you're thinking about managing risk?
Bill:The first thing, particularly if we think about it through the lens of the credit side, it's a really deep understanding of the businesses that we lend money to. When we look at these companies, we're really thoughtful about what could go wrong. So if I'm buying a stock, there's a lot of embedded hope and expectations into what future earnings will be, because I need that stock to go higher, to be driven by something. I need a catalyst to drive that stock higher. Our CIO, Dave McGarrel, talks a lot about what's the catalyst right? When it comes to the bond market, it's more about risk management. So we have to be thinking about what could cause us to lose money, because our upside is limited typically to earning our coupon and getting our money back. So we're very thoughtful about where the volatility could come from.
Bill:So that's where it comes back to taking those hundreds of earnings calls financial modeling. Even through all the work that's done across all the various sectors, whether it's securitized sector, municipal sectors, corporate sectors, all the way through. It's that deep understanding of where the risk resides. And you know we're not. Our base cases aren't built on hope and dreams. If you will that really, when you see stock multiples expand that you really need to. You need those earnings to come through to support those stock multiples. For us, we're trying to ensure that when we're buying a bond in any capacity, that it's a durable investment, that we're not taking an excessive amount of risk relative to the return potential in that bond, and that comes through an enormous amount of work that has to be done upfront to ensure that we're protected.
Ryan:What I'm hearing you say is, in particular, security selection is really where you can do that work to know those businesses and maybe the duration positioning key rates, something like that, is also important. But for the funds that you manage, would you say that security selection is really the key, very important.
Bill:We're going to use all the tools that we have. So each one of these things whether it's duration management, credit selection, diversification, liquidity each one is a lever that we can pull as an active manager to try to drive value through the strategies that we manage. Great.
Ryan:Well, time's flown by once again, Bill. Last time you were on, by the way, you mentioned this book about Teddy Roosevelt, River of Doubt, and I read that book Really fascinating story. Put you on the spot again, Because I'm always looking for something to read. What would you recommend myself and the listeners to the podcast? What should we check out next?
Bill:One book that I would definitely recommend is David Horowitz's A Radical Son, a Generational Odyssey, and it's a great book about his journey as a 1960s revolutionary to a conservative thinker. So is that an autobiography?
Ryan:Yes, it's an autobiography. Okay, fascinating. We will add that to the ROI podcast reading list. Bill, thanks for that book recommendation. Thanks again for coming on the podcast. Hopefully you can come back again. Thank you, ryan, great to be with you again, and thanks to all of you for joining us on this episode of the First Trust ROI podcast. We'll see you next time.
