Stick With the Shorter Side of the Yield Curve in This Market

The Fed has finally capitulated. Now what? On Tuesday, Federal Reserve Chair Jerome Powell said that the Fed will act as appropriate to sustain the expansion. Later that same day, Vice Chair Richard Clarida followed up by saying they would put in place policies that would not only achieve but sustain price stability and maximum employment. Make no mistake, this was the Fed making a purposeful communication to the markets: A cut is probably coming. Here's what this means for markets looking forward. Are we sure this means the Fed is cutting? Given Powell's checkered communication history, we can't be completely sure of anything. However, this was about as explicit as the Fed gets, and it is absolutely true that now Powell must follow through with a cut or really risk his credibility. The next Open Market Committee meeting is June 19, and the Fed doesn't necessarily have to cut at that meeting as long as they basically promise to cut at the July 31 meeting. Anything short of that would be extremely problematic. Why? Because it would effectively be the second time Powell has cried wolf, and both times in response to a falling stock market. Each time he does that, he reduces the value of his words, forcing him into more dramatic action to get the same response. Stocks fall dramatically in December, Powell promises to ease off in January. Stocks fall in May, Powell promises to cut in June. In both cases (at least based on yesterday), the market took him at his word and rebounded. However if he doesn't actually follow through, the market will start to ignore his words and wait for actions. Monetary policy isn't just about the Fed's targets Monetary conditions aren't just Fed policy. Every day, financial conditions get a little easier or a little harder based on lending standards, credit spreads, liquidity in markets, etc. In this sense, monetary policy changes all the time. This is why credibility of the Fed's words is so important. By promising to back off rate hikes in January, Powell got monetary conditions to ease a bit. Often, the Fed wants to get markets to ease up a bit without having to use the bazooka of actually cutting rates. It is a very important tool in the Fed's kit. I sure hope Powell doesn't ruin it by not following through. The melt up may be back on If the Fed is out of the way, it removes the biggest obstacle to stocks resuming their climb. What is uncertain is whether enough damage has been done by either overly tight policy already or by trade uncertainty. We will see, but my suspicion is that in the short term, we'll get a lasting rally. Why did Treasury yields rise after the Fed promised a cut? As I write this, I'm on the road seeing clients, and even as it was happening yesterday, I was getting questioned on why rates would rise the day the Fed made such strongly dovish comments. It is actually quite simple. The longer policy remains too tight, the more damage is done to the economy. It takes more-aggressive monetary policy to repair damage than it does to avoid damage in the first place. So the longer the Fed waits to make some cuts, the more they are going to have to cut later (and probably also the longer they are going to have to keep rates low). If the Fed cuts a couple of times in 2019, the odds of a 2020-2021 recession go down. As I've written before, if we get a recession in the next couple years, it is a near guarantee that the Fed will be forced to cut rates to zero. Speaking strictly from the perspective of a 10-year Treasury owner, that zero rate scenario is the best case. If the odds of that best-case scenario diminished a bit on Tuesday, it makes sense that rates should be a bit higher. This is why I've been recommending owning the 5-10 year part of the curve and not longer bonds. The longer the bond, the more it is tied to GDP growth and not near-term Fed policy. As of early Wednesday, the 5-year Treasury has recovered more than half of its losses from Tuesday. The 30-year is still selling off. What to trade now? I am completely comfortable sticking with my 5-10 year long position, although it could certainly experience some choppiness if inflation surprises. I still think the risk/reward is good. I like adding the iShares iBoxx $ Investment Grade Corporate Bond ETF for a trade. Corporate bonds, and especially investment-grade bonds, should get a nice boost from stable-to-falling short-term rates plus easier Fed policy. You can look at the iShares iBoxx $ High Yield Corporate Bond ETF or the SPDR Bloomberg Barclays High Yield Bond ETF as well, but the risk/reward is best in BBB-rated bonds, which makes up most of LQD.

Stick With the Shorter Side of the Yield Curve in This Market

This is why rates rose the day the Fed made such strongly dovish comments, and how you should manage your fixed income portfolio in response.

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