Webinar Replay

Is the Fed Fighting Yesterday's Battles?

March 22, 2023

During this Office Hours replay, Global Chief Investment Officer Jeremy Schwartz and Head of Fixed Income Strategy Kevin Flanagan discuss the developments from the March 2023 FOMC meeting. As part of this discussion, they address what investment solutions investors may wish to consider based upon the outlook for U.S. monetary policy.

This webinar was simulcast on Zoom.

Irene Webb:
Hi, everyone. Thank you for joining today's post-Fed reaction Office Hours with Wisdom Tree titled, Is the Fed Fighting Yesterday's Battles? Where you will hear from Jeremy Schwartz, Wisdom Tree's Global Chief Investment Officer, and Kevin Flanagan, Wisdom Tree's Head of Fixed Income Strategy. So with that, I'll turn it over to Kevin to get us started.

Kevin Flanagan:
Thanks, Irene. Good afternoon, everybody. We could have called this one a lot of things. Fighting Yesterday's Battle, Walking the Tightrope, Threading the Needle, On the High Wire, you name it, right, before we came in to this Fed meeting, considering what we're living with and dealing with in the markets in this post-SVB/Credit Suisse we've got to add to the conversation world now.
But I think the outcome was widely anticipated, the broad outcome. We'll get to some of the other stuff in a minute. In other words, the Fed raising rates a quarter point to 4.75%-5%, that's the new Fed funds trading range. Now you'll see everyone, they'll say this is the highest since 2007. But if you want to get technical about it, this is the highest in a rate hike cycle since the 2004, 2006 cycle. Remember, the Fed went on hold for a decent period of time before the Financial Crisis hit. So just kind of splitting hairs there a little bit, but that's where we're at, right? This is the most aggressive rate hike cycle since Paul Volcker, and in terms of absolute numbers, the highest rates that we've seen in roughly, let's call it 16, 17 years. It's just incredible. And back to the point we've made many times about rates being at levels a whole generation of advisors and investors have never seen before.
But we want to get down to this because it's 30 minutes, and I wanted to pass it over to you, Jer, because we had a bunch of questions come in. We like to keep these Office Hours, these presentations, very interactive with questions. So we had a bunch come in that we're going to answer as we go along. We may not say specifically, "This was the question," but we'll more than likely be handling that, per se.
But there was one that came in, Jer, and I had to tee you up, because working with Professor Siegel, Dr. Siegel, and seeing what he's been saying lately, one of the questions we got, Jer, I want you to kick this off, is, "Why isn't everyone saying how bad Jay Powell is?" So I don't know if you wanted to start off with that question or lead into it.

Jeremy Schwartz:
This is a question from Kirk, so Kirk, thank you for this question. And when you say, "Why isn't anybody saying how bad..." The question is, "How many of these calls have you attended?" because one of the questions with Professor Siegel is hammering Powell. He is not... No sympathy for Powell, and has been saying that this is perhaps among the top biggest mistakes ever of a Fed, ever. And so, George asked a question about why did the Fed wait so long to start hiking rates? This is part of why we're going to answer two of these questions at the same time. Why did Powell miss it going up, and now he's missing it, in many ways, coming down?
Coming back to inflation, he's looking at backwards-looking data. He's confirming today all backwards-looking data, and not at all trying to assess what's happening in the real time. Now it's interesting, the markets at first reacted, just with the dot release, they sort of say, "Hey, it was well-telegraphed 25 was coming. They were going to say the banking crisis was separate, financial stability concerns were separate than their monetary policy inflation fight. They're going to keep the 25."
You saw all sorts of people, including Siegel, say they can't give up on the inflation fight narrative because they'll say, "Hey, what do they know about the economy? They don't really know anything that we don't know about the uncertainty coming here." You did hear uncertainty quite often. And there was more questions about bank deposits. And sort at the same time that Powell was speaking, there was also some headlines crossing from Yellen saying, "We're not going to expand broad deposit coverage," which is a big mistake. They should be doing broad deposit coverage. They need to up the limits from $250,000. And well, there's pressure on the banks, less even from panic about, "Are the banks safe?" And you saw the banks sell-off hard in the closing hour of trading. The small caps were down more because they had more bank exposure. The regional banks were down a lot.
The problem is, and there was a direct question to Powell, "Is your rate hike going to make it worse on banks?" Yes. Yes, it is going to make it worse on banks. Why is it going to make it worse on banks? Because you can get 5% in floating rate Treasuries. You can get short-term Treasuries at much higher yields than these banks are paying out. The deposit flight, not for safety fears, for real, "I could earn 5% and I don't want to be leaving my money earning 0% when I could earn 5%." And so, the deposit insurance, there's some estimates. Siegel had quoted on one of our recent calls that they're talking about like 10 basis points it would cost to insure all deposits. When the banks are costing you 4-5% by just keeping your money in the bank anyways, the 10 basis points is nothing. They need to do something to dramatically increase the protection, because that deposit flight is going to continue going towards Treasuries.
There was more questions about commercial real estate at these banks. "Hey, we think the banks are well-capitalized, until these deposits continue to move out." And that's going to be one of the continued themes, I believe, is going to continue to pressure the banks. They're just not raising rates fast enough to keep money well-deposited. So that pressure's there. So Kirk, why isn't anyone saying how bad Powell is? We grade Powell, we've been saying D, because you couldn't give anybody an F. And Siegel is been saying he should be fired, aggressively saying he's not doing the right stuff. So we're on the boat that we are saying Powell has been mismanaging this dynamic. And so, I don't know, Kevin, do you want to react to any of that?

Kevin Flanagan:
Well, yeah, no pun intended, right? There's no grading on the curve here. This is just straight talk here about Powell. There's no doubt about it. I'll tell you. Before "The inflation is transitory," I think history was probably going to be pretty friendly to Powell on gambling and getting us through the Covid lockdown and what occurred, hit there. But geez, ever since inflation gained the toehold, "Inflation is transitory," and now perhaps going too far on the other end of the equation, and what's occurring. You're seeing on the bank deposit side, that's not something Powell can control, right? That, I think, is a problem for the banks.
Banks have always lagged a little bit below the Fed funds rate, but this time around, the spread between bank deposits and Fed funds is one of the largest, if not the largest we've ever seen on record, creating, Jer, the environment that you were saying, that is you're an investor, why hold your money there? Right? Why not put your money into Treasuries or floating rate Treasuries, something along those lines?
But what I find interesting in the conversation is we wrote a mind on markets piece about this I think two weeks ago. I come from the old school, where the Fed usually really didn't talk all that much. And sometimes, the more the Fed talks, the more trouble they get in. And I think that's what we've been finding out lately. Just think about the month of March. You go back two weeks with his semi-annual monetary policy testimony, the shot across the bow. And the next thing you know, the two-year treasury yield goes up to 507 based upon that because it's seemingly we were going to be arguing in a pre SVB world, whether today was going to be 25 or 50, not zero or 25, and now it's just the opposite where we're going here. So it's really difficult. Sometimes you wonder if they should have just released the policy statement where they threaded the needle okay. They raised the Fed funds rate. They acknowledged the risks had risen or the uncertainty had risen with what's gone on with recent developments in the banking industry and tightening credit conditions. Maybe they are worth a rate hike or two going forward.
Just leave it at that. You just saw what the markets did. Everything seemed to be okay. It's at the press conference when all things fell out of bed there. So I don't know. My advice no one's going to listen to at the Fed is sometimes maybe he should have just gotten up there and read the policy statement and said, "Thank you." And that's the end of it. But I think what's more important is where are we going from here? I think that's going to be a lot of the conjecture. And there's one thing that ... is there still that disconnect. There's one thing that just keeps coming back to me, and it's been throughout the latter stages, or let's call it the latter half of this rate hike cycle up to this point. And that's the market's expectations for rate cuts.
Every time the market moves in that direction, they're coming sooner rather than later. More in terms of where Fed Funds will be, in other words, lower in Jan 2024 than initially thought. Something happens and that trade gets completely wiped out. Here we are again, it really is like Groundhog Day, for a lack of better way of putting it. We now have Fed Fund's futures looking at a rate cut this summer and taking you down to perhaps the low 4% by Jan 2024. And it's just fascinating to see this dynamic play out on where we're going to go. And what does Powell say? Powell says, "Fed officials just don't see rate cuts this year." So there's that other disconnect of what's going on and it's just ongoing. Don't fight the Fed, don't fight the tape, don't fight the markets. It's just this powerful two forces that we're just going to continue to see play out for the better part of this year.
And this was without all of the volatility uncertainty we got from the latest banking, let's call it semi crisis. Because for all intents and purposes, something you mentioned earlier before Jer, about what the Fed has done in terms of their facilities and monetary policy is for this, it's not for that per se. Seems to have calmed things down for now, anyway. Let's hope, fingers crossed. But to me it's like, where are we going here? And when you just looked at the policy statement, these were my first thoughts and I actually sent this out, was they didn't open the door and they didn't close the door for a rate hike in May. It's data dependent, it's financial condition dependent. The dot plot, as you said, Jer, is still 510 for the terminal rate for this year. So we've gone nowhere. In other words, had all this news, all this information in the first two weeks of March and we're right back to where we were.
So let's look at it. Could you get a rate hike in early May? Well, if the economic numbers come in as they did for January and February and things calm down in the markets, yeah, why not? I don't think you can rule it out. But if you get this kind of reaction in the markets and a tightening in financial conditions going forward, then perhaps this ends up being the last rate hike. So the ball's up in the air. We don't know. That level of uncertainty has risen. So when you're looking for investing, and Jer, I want to turn it back to you on this. How do you invest in this? When you're looking to put money to work? What should you be thinking about?

Jeremy Schwartz:
And Irene, I think we also ... did we get one poll question in there for people? So we put one question. How many rate cuts will take place in 2023? Now if you think they're going to keep hiking, you can answer zero. So for the hawkish people here, zero is your answer. Then we put two, four and more than four. Curious what our audience is saying in terms of how many cuts, no cuts, or somewhere between two, four, more than four. We'll see how aggressive it is and we'll try to compare that to what the market's saying. Very curious to see how our audience is saying this. Kevin, with a two-year now at 393, the inversion of the curve, 5% basically upper bound of the Fed Funds range, the two year at 393, what's that saying? That in itself has a forecast of cuts essentially. How many do you think the market's pricing in at this moment in time?

Well, there you go. I think this is interesting looking at this, because I think I'm somewhere in this camp with the polling questions. If we get four or more this year, which probably means they do start in the summer, you know what that means. It's not good. It's not good. It means the banking conditions are not getting better, maybe getting worse and the economic numbers are rolling over. So to get to that point in the discussion is probably not good. The zero to two I think is interesting at this stage of the game. But to your question, Jer, it was kind of the trifecta. You mentioned the first thing. Money moving out of deposits into treasuries, you had flight to quality and you also had a situation where we're repricing where you think Fed Funds are going, not just for 2024 or whatever, where we're going as soon as say 3, 6, 9 months from now.

And I think that's what you're seeing playing out in the market at this stage of the game. And when you do get flight to quality or safe haven buying the whole treasury curve benefits, but usually the money goes into the shorter end, because you don't want that speculation that gets tied in with something like a 10-year or a 20-year or a 30-year maturity. So that's what you see going on here, and back to what we were talking about before, a question came in, where do we see the 10-year yield at the end of this year? If you would've asked me a couple of weeks ago, I would've said maybe around here, maybe three and a quarter, something like that.

But you kind of wonder now it's like, okay, you've had this huge rally again in the 10-year treasury, how does it get lower than this? Well, how does it get lower? We're going to get bad news. That's how you get lower than that. So initially I would've thought three and a quarter was probably a good call for where you would end this year, but you're getting darn close to that now. Matter of fact, last week, once again, we were in the 330s based upon this banking headlines that we were seeing out there. And one other question I wanted to get to as well, it's important Jer, I'll throw it back to you because I see we just got a few more live questions come in. A question about mortgage-backed securities. Spreads have widened out there, but it's been, let's call it somewhat orderly. And we noted this, Jer when you and I did the claw with Professor-

Kevin Flanagan:
We noted this, Jer, when you and I did the call with Professor Siegel last week as well in the credit markets in high yield where we have seen spreads widen out, but it hasn't been of that heightened anxiety type of widening, it's been a more reasonable orderly kind of move where you look at this and you wonder, does it actually potentially represent some buying opportunities here? Especially in our opinion, perhaps on the high yield front. So with respect to mortgage backs, it just goes par for the course. I think what you were seeing here, you're about 15, 20 basis points above the five-year average for mortgage back. So nothing crazy. Nothing crazy. Some cheapening in the market for sure, but nothing out of the realm of you're saying, ""Oh geez, all these markets outside of treasuries are getting tattooed." So I don't know if you've taken a look at any of those three questions that have come in?

Jeremy Schwartz:

Yeah, well first I'd say just to comment on the polls, I think this poll is really interesting that only basically one person on this call thought it would be more than four. So that itself is telling. I think there is... If I was answering this question, I might have been one of the people answer that more than four. Most of the people here, two thirds said zero. Somebody had wrote in, Tim wrote in saying he put zero because he thought Powell was going to try to not make a mistake but then prove to be really making a big mistake. So good reflection on Tim there on that. And then a third of the people put two, and so interesting. It will all be telling on what actually happens with inflation, what actually happens in the banking dynamic. Does it really deteriorate in a way that does make it to be a little bit worse of a situation? So very interesting poll results.
I guess, Kev, did you want to talk about in what to do for, again, thinking about just the additional 25 you're getting, let me go back before we get into a few what to do about it. So Lily wrote in this question, coming back to probably my opening comments, "Is it unfair to blame the Fed and Chair Powell about not raising rates sooner because of the COVID pandemic and all the rest?" And sympathetic to that Lily and obviously COVID was unique and there's all sorts of dynamics that were unique, but we still give Powell very poor grades on his conversation around the money supply. I mean this is the money supply shrinking now is one of those concerning signals that Powell has not really talked about at all. He missed it on the way up where he had this 40% cumulative increase in money supply. The Fed was saying there's no relation between money supply and inflation. The long-term data does show there's relationship between money supply growing and inflation coming out later.
And you had a record increase, and not just because of the Fed. I mean it was all the pandemic relief measures which were appropriate at the time, but then the Fed financed it by buying all the bonds and if they didn't buy all the bond rates might have rose sooner. It would've been tougher. There would've been less inflation, ultimately, what he was saying it was transitory in 2021, there was a lot of inflation in the system. It comes back to his backwards looking data problem. He's now saying, you heard them say today, the real estate is actually coming way down. The new leases are coming way down. They know their data is misleading, which for 40% of core PCs misleading, but now he's worried about services, ex-real estate or ex-housing. But he could have been saying inflation wasn't erring in 2021 and they could have done a lot more earlier because of what was actually happening in the world and not from data.
And so again, we think a lot of the data is starting to show things cooling off in more than their official data. So that that's going to be one of those issues. So we do still think it's fair to give him a hard time on that question.

Kevin Flanagan:
So I mean, Jer to your point, I mean let's go back. We were talking about the two year, we've mentioned Treasury floating rate notes. So what I have found interesting is that in the environment we've been in, rate hikes, rate hike cycles still on. They haven't paused yet, maybe they will, but they haven't yet. Rate cuts according to Powell, not being considered so far for this year or talked about, and volatility. So a lot of money is moving into say, shorter data treasuries in that one to three year area. The degree of volatility that has been witnessed, not just over the long run, but even more recently in that part of Treasuries, I think would surprise a lot of people out there per se. And to us, that's why we've always looked to Treasury floating rate notes as kind of knocking off something at the same time where you can get the income without the volatility.
And since it's tied to the weekly...option, you're getting more "real time" type of adjustments and it's not a fixed coupon. So you're not having these speculative forces they're going to cut, they're raise, they're going on hold, flight to quality money going in. I mean, you're not getting that kind of movement in the market.
[21.59] And some people will say, "Well, at some point the fed's going to cut rates, right? We had the poll in question." "Yeah, they're going to cut rates, but you know something different this time around, is where are they going to cut rates from?" Think about this for a second, say this is it, that they start at 5%. Do you know that that's double where we were in the last fed rate hike cycle back in where we were in the last Fed rate hike cycle back in 2018, when we were around 2.5%. So the starting point here, so even if they start cutting rates, they have to cut a lot to get back to the point where it's like, "Oh, geez, one week duration." I mean, if they cut rate 100 basis points, 150 basis points from here, you're still looking at 3.5, 4%, with something with one week duration. The 10-year treasury note is trading at 344 right now . Think about that. Just combine those two thoughts together and you see why this remains one of our main high conviction ideas [22.58] for the investor in the environment, not just that we were in pre-SVB, but post-SVB as well.

Jeremy Schwartz:
Yeah, no, I think that is very relevant on a Fed hike day. And even on the cut dynamic, I think your point is well taken. They're not going to have the NAV volatility. They will still have the inverted yield curve. Very interesting dynamic, which is challenging to the banks. It goes into one of Tim's questions here. Should the Fed have done less with rate hikes and more to shrink its balance sheet to normalize the yield curve? I mean, it's a very interesting question is with this QT ongoing, the powerful force that people believe this is tilting us towards recession is weighing on all the rates, besides for the one-week duration and six month type treasuries, do you think they should have done more with QT, Kev?

Kevin Flanagan:
Well, I mean, is it the lesser of two evils? Because if you are more aggressive with QT, does that disrupt and create dislocations in the funding markets? We saw that in, I think, it was 2019, where the Fed had started quantitative tightening, drawing it down, had to stop it, and then reintroduce quantitative ease to help with some of those dislocations in the funding markets. Especially, I don't want to go too far down the rabbit hole, because I know we only have a couple minutes left, but it's an on the run, off the run issue.
So for treasuries, the on the runs are the most recent issue that was auctioned. The off the run is, say, an older two-year note, an older ten-year note that doesn't get the same kind of attention or perhaps investor demand, and that can be skewed by what the Fed's doing, right? Unloading on their balance sheet. We've seen this pop up time and time again. So once again, to use that expression, trying to thread the needle of what the Fed's trying to do. I saw, based upon Powell's comments today, they didn't talk about changing their QT schedule. So is that something that could be coming up? Yeah. So once again, it's a combination. It's not just rates. It's also QT that the Fed could focus on going forward, if they needed to make changes.

Jeremy Schwartz:
So Kevin, and today's appropriate to focus mostly on fixed income and the Fed and all that. I want to give one comment on equities just of where I still see some opportunities within the equity world to say how should people be thinking about sort of core equities, where they should be positioned? We've talked a lot about quality focus. You're hearing that as one of those factors with volatility, quality, how you define quality matters. This is dividend growth quality. I did a blog recently talking about Warren Buffett's focus on high profitability. He highlighted Coca-Cola, American Express, things he's held for 30 years, all the dividend growth he's had in them. It's sort of symbolic of what we do in DGRW and we've held Coca-Cola and American Express, basically overweight since we launched this 10 years ago.
DGRW'S held up with all this volatility you've seen in market, has been sort of a value cycle last year, sort of more expensive stock, selling off value, doing well. The focus on quality dividend growth, reasonable multiples by weighting by dividends as just one of our favorite core long-term strategies. I think now is the moment where that focus on profitability really helps, and we emphasize this as one of the core positions. We use it in most of our model portfolios as the anchor to our U.S. large cap. I think that still remains very relevant.
If there's more issues with the banks, I think that that value side could still come under some pressure there. And DGRW has a much less than the traditional value. We wanted to keep today's call short to 30 minutes. We didn't do it for CE credit today, but any wrapping closing thoughts from Kev?

Kevin Flanagan:
No. I mean, the volatility quotient is elevated. Just be mindful of that. That's not going to change anytime soon, and we're just going to continue to see a very highly data financial condition-dependent Fed going forward.

Jeremy Schwartz:
Well, very good. Thanks everybody for tuning into our timely markets calls. These are always great to get the reaction and thank you for joining us here. Irene, thanks for helping host, put this together. We'll see you all next time.

Kevin Flanagan:
Take care, everybody.