Market Outlook

April 1, 2024

D.C.’s Policy Makers Make Fed’s Inflation Fight Tougher

With the first quarter of 2024 in the rearview mirror, investors have certainly encountered plenty of surprises. For some, it’s that the nearly uninterrupted rise of growth stocks has gone hand-in-hand with more defensive sectors (like pharma and cyclicals) gaining traction. This broadening is explainable by the benefits of "rising tides lifting all boats." But that’s not the whole story.

What’s most impressive is that major equity indexes have extended their 2023 run into this year (see p. 5) and, in so doing, have soared into record territory. Remarkably, this has occurred even as the Fed Funds rate remains at a 23-year high. Granted, last year’s bull market also resisted the gravitational pull of generationally high borrowing costs. But stocks appreciated amid the promise of modest GDP and corporate earnings growth and, more importantly, the prospect that slowing inflation would eventually lead to rate-cuts by the Fed (even though the CPI was well above the long-term goal of 2%). Though inflation finally dipped to 3.0% in June 2023, by early fall it was back up to 3.7%, but since has fallen below 3%. Obstinately range-bound between 3.1% and 3.4% since November, one has to wonder if some invisible hand of economics is making the Fed’s long-term target impossible to reach.

Which brings us to the federal deficit.

Last week it got plenty of attention, and not only because the federal government is poised to run out of money most months. It was because the Congressional Budget Office weighed in on the matter with some very sobering statistics, and this message: The projected cost of financing the federal deficit is expected to soar with the possible (and unwelcome) consequence of anemic GDP growth over the long term.

But I’m jumping ahead.

Having already punted twice this year (in January and March) on rate-cuts, and with plenty of sound reasons to avoid a cut at its May 1 meeting, some bond investors are clearly concerned about the Fed’s lack of easing. But they shouldn’t count on Chairman Jerome Powell empathizing, because he’s been clear that premature rate-cuts could trigger an undesired result: inflation heating right back up again, making the Fed’s battle even tougher.

It seems like the market has gotten the message. Thanks to significant headway on inflation and another pass last month on a rate-cut, all 25 of Fidelity’s taxable bond funds gained ground in March (though first-quarter results were mixed).

Fed vs. Policymakers
For what it’s worth, much of the Eurozone is struggling with a similar conundrum as our own Fed: monetary levers are hamstrung by Washington policymakers (Congress and the White House) who ultimately control the nation’s fiscal levers (spending and taxation). At the risk of my stepping on political sensibilities, generational mismanagement that has led to $34 trillion in national debt places upward pressure on inflation. (The interest we pay on that debt now exceeds all defense spending.)

While partisans and policy wonks are free to debate the matter (and its solutions), high deficit spending and high inflation are not coincidental. Nor is it a twist of fate that, in recent years, two of the country’s three major rating agencies modestly downgraded Treasurys having cited the country’s deteriorating balance sheet (Standard & Poor’s in 2011 and Fitch in 2022).

In an August 2023 white paper, Fidelity addressed the matter: "Research from [our] Asset Allocation Research team suggests that higher debt is not a recipe for faster economic growth, and that the responses by policymakers to that debt can ultimately lead to higher inflation and more volatile financial markets than in the past."

Though an imperfect way to measure bond risk, Intermediate Treasury Index fund has a relative volatility of 0.41 (versus 1.00 for the S&P 500). Prior to Fitch’s downgrade, it was 0.35 — a significant change for a bond fund, generally, and for a Treasury fund, in particular.

It’s possible that some combination of increased productivity (perhaps instigated by advances in AI), higher GDP growth and/or slowing wage growth will improve America’s balance sheet (and perhaps restore Fitch’s highest AAA rating from its current AA+). While it’s true that U.S. government bonds in all their varieties remain among the safest in the world, given this country’s unique position on the world stage (economically, politically and militarily), there can be no margin of error.

Action Recommendation
Improving the country’s balance sheet at a time when Washington is so divided suggests that matters may get worse before they improve. Against this unfortunate backdrop, high-quality corporate bonds may be a safer play in the years ahead. Consider, for example, these alternatives: Short-Term Bond over Short-Term Treasury Index, Limited Term Bond over Limited Term Gov’t, and Intermediate Bond over Intermediate Gov’t Income.

Granted, in a credit crisis their relative performances may be negligible. But until there are clear signs that Washington’s leaders are willing to lead, the nation’s budget woes will likely worsen. That means U.S. Treasurys, in all their variations, risk losing their unique global status.

— John Bonnanzio