Federal Reserve Chair Jerome Powell on Friday did little to dissuade markets from the “higher for longer” mantra for rates that has driven up Treasury yields in recent weeks, leaving some investors looking for more cautious bets in case the economy is unable to escape a downturn next year.
Speaking at the Kansas City Fed’s annual gathering in Jackson Hole, Wyoming, Powell left open the possibility of further rate increases and stressed the U.S. economy’s surprising strength, though he acknowledged declines in the pace of inflation over the past year.
While more balanced than the Fed chair’s ultra-hawkish address at last year’s symposium at Jackson Hole, the speech nevertheless offered little solace to those hoping the central bank would nod towards eventual rate cuts in 2024.
For some investors, the view also reinforced worries over the risk that higher yields will eventually weigh on the economy’s robust growth and bring on a potential downturn, though most believe the U.S. is likely to avoid recession in 2023.
“The recession risk is out there for 2024, and as such we want to … make sure we’re in corporate debt that is well situated to sustain a downturn,” said Cindy Beaulieu, managing director and portfolio manager at Conning, which manages $205 billion.
“Those types of trades are important right now as opposed to trying to take additional credit risk,” she said.
Financial markets on Friday saw little of the volatility that accompanied last year’s Jackson Hole confab, when stocks sank more than 3.4%.
Yields on the benchmark 10-year Treasury, which move inversely to bond prices, were flat on the day at about 4.239%, though they remained near 16-year highs hit earlier this month. Two-year yields - which are more closely linked to monetary policy expectations - added about three basis points.
Stocks - which have wobbled in August as rising bond yields threatened to dull the allure of equities - were little changed with the S&P 500 up 0.22%. Options markets were pricing in a move of around 0.9% in the index ahead of the meeting.
The surge in bond yields over the last few months - driven by bets that the Fed will need to keep rates around current levels for longer than expected to prevent inflation from reigniting - has rippled out into the economy, pushing 30-year mortgage rates to their highest level in over 20 years while credit spreads, a measure of risk, widened slightly this month.
Investors said much depended on what the next few weeks of data show. The U.S. will report labor market data for August on Sept. 1, and consumer price data on Sept. 13.
“Powell appears to be buying time and waiting for more data to come in so that they can set themselves up to continue the soft landing trajectory,” said Anders Persson, chief investment officer, global fixed income, at Nuveen.
REVIVING RECESSION WORRIES
Some investors were worried that higher rates could weigh on growth and increase the chances of a recession next year. Such a scenario, in theory, would force the Fed to cut rates, pulling bond yields lower.
“The prospect of a soft landing is lower after today,” said Mike Sewell, a portfolio manager at T. Rowe Price, who expects to add to long-term bonds over the fourth quarter as the U.S. economy begins to weaken.
“We are waiting for financial conditions to crack,” he said.
Fed funds futures traders were pricing for a total of nearly 100 basis points of rate cuts next year, roughly unchanged from bets prior to Powell’s speech, but the first rate cut was pushed out to June from May.
To be sure, betting against the U.S. economy has been a risky endeavor this year. Many banks have reversed calls for a 2023 recession in recent months, while bets on economic resilience have helped fuel a 15% rally in the S&P 500 year to date.
At the same time, many investors appear convinced that yields are going to remain elevated for the time being.
Hedge funds’ bearish bets on long-term U.S. Treasuries have built up over several weeks, with net short positions in 10-year U.S. Treasuries futures at their highest levels since the beginning of July, according to Commodity Futures Trading Commission data from last week.
“The market is very short,” said Josh Emanuel, chief investment officer at investment management firm Wilshire.
But while risks remained that long-term bond yields could move higher, he was looking to extend the duration of his portfolio. “We are technically neutral today, but becoming increasingly bullish on long-term Treasuries.”
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