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Fed Rate Cut Late In First-half Of 2024?—creates Reinvestment Risk For New Short-term Investments Made Early In 2024 –record Budget Deficits–higher Rates For Longer—end Of Abnormal ”cheap Money” Era?—attractive Real Long-term Treasury Rates—2017 Tax Law Expires In 2025—2024 Elections Key To New Tax Legislation—

Date Posted: October 31, 2023

Higher for Longer—The Likely First Rate Cut—Reinvestment Risk for Treasury Bills Follows

Our previous Commentaries focused on how the Fed’s failed stop-and-go rate experience in the seventies could potentially shape current policies. Given those concerns, members of the Federal Open Market Committee (FOMC) project only two rate cuts for 2024 as they emphasize a “higher for longer” funds rate approach. The minutes of the Fed’s September meeting also indicate they might continue shrinking their balance sheet even after initiating rate cuts. Looking at recent history, the Fed typically waited 7-14 months after reaching its peak rate before implementing rate cuts (see Figure 1.) Assuming the peak rate increase likely occurred in July, then, a rate cut seems possible late in next year’s second quarter. Once the Fed cuts rates, short-term rates will likely experience a significant decrease. According to J.P. Morgan’s fixed-income strategists, in the past eight Fed tightening cycles, bond yields declined an average of one percentage point after the final hike. If the historic pattern repeats, early next year, we may face reinvestment risk for new positons in Treasury Bills and other short-term fixed income investments at the end of their investment term.

Figure 1
Federal Reserve, Upper Limit of Policy Rates

Sources: Federal Reserve Data, WOLFSTREET.COM

Increase Federal Deficits Eroding Financial Market Confidence in Our Political System

Political dysfunction in Washington increases concern among investors that the federal budget deficit will be heading towards eight percent of GDP (see Figure 2.) Despite the resilient economy with historically low rates of unemployment, the FY 2023 federal budget deficit doubled to $2 trillion or 7.5 percent of GDP. The deficit increase can be attributed to reduced capital gains taxes resulting in a revenue loss of $456 billion. Another signficant budget funding decision awaits Congress in mid-November when the stopgap funding bill expires. Unfortunately, resorting again to last minute media circuses to address these critical budget funding decisions only further undermines confidence in our political system. Some regard politics as the art of compromise and as Bismark famously said “Politics is the art of the possible.” Regrettably, Washington today seems to lack politicians who embody these definitions thus making compromise impossible in the current climate.

Figure 2
U.S. Forecasted to Run Large Budget Deficits(% GDP)

Source: Congressional Budget Office

Treasury Debt Real Rates Attractive–First Time Since the Great Financial Crisis

Strong economic growth plus higher inflation prompted the Fed to rapidly hike the funds rate to control inflation. Initially long rates remained relatively low for some period. Apart from inflation, other factors, not easily measured, can influence the term premium and thereby long- term rates. An important turn in long-term rates came when investors realized the rapid growth of the federal deficit would lead to higher debt issuance to fund it. Adding to this pressure, foreign holdings of U.S. debt seem to be peaking and at the same time the Fed continues to reduce its balance sheet (see Figure 3.) These factors combined likely contributed to a rapid increase in long rates, with the 10 year Treasury note briefly touching five percent. Nonetheless, inflation still will be the key driver of interest rates. Despite the Fed’s target inflation rate of two percent, sticky services inflation will likely help keep Core PCE inflation higher averaging around 2-3 percent for an indefinite period beyond 2024. This outlook contrasts with the sub-2 percent rate for Core PCE inflation experienced in the last decade (see Figure 4.) Expectations for higher inflation and interest rates will likely signify the end of the abnormal “free money” era that characterized the last decade. Overall, these changes will place greater burden on private borrowers as they will need to step up their purchases of increasing Treasury debt issuance. Unlike central banks, private investors seek to earn a real rate of return on their Treasury investments. The resulting higher current interest rates offer attractive real rates of returns on Treasury notes and bonds, marking the first time since the Great Financial Crisis that will be the case.

Figure 3
U.S. Foreign Owned Debt—Adjusted for Inflation, 2000-2022

Source: U.S. Department of the Treasury

Figure 4 
Core Personal Consumption Expenditures Inflation20142023

Sources: Bureau of Economic Analysis, Federal Reserve Bank of Cleveland, Haver Analytics

Treasury faces Increased Interest Cost from Rolling Over Large Share of Short-Term Debt

Unlike many home buyers, the Federal Government did not take advantage of low long-term rates. Instead, it increased its use of short-term debt with the average maturity of U.S. government debt approximately six years and roughly half maturing in three years or less (see Figure 5.) Rolling over this substantial short-term debt position at higher interest rates along with the need to fund increasing deficits will result in a doubling of interest costs relative to GDP. This level of interest costs will be the highest ever recorded (see Figure 6.) This will pose a key political issue as interests costs will exceed spending on all discretionary programs (see Figure 7.)

Figure 5
Treasury Bills Outstanding as a Percent of Total U.S. Government Debt

Sources: Simon White, Bloomberg, The Daily Shot

Figure 6
Net Interest Cost Projections as a Percent of GDP

Sources: Congressional Budget Office, Peter G. Peterson Foundation

Figure 7
Federal Government Spending on Interest Discretionary and Mandatory Budget Categories

Source: Congressional Budget Office

2017 Tax Law Expires in 2025—Prior Tax Rules Return–Key Taxing and Spending Decisions will Follow—2024 Elections will Help Determine their Direction

The 2017 tax legislation sunsets at the end of 2025. Without new legislation, the old tax rules that existed prior to its passage would be reinstated. This expiration will force key decisions on taxes and spending potentially leading to higher tax rates, spending reductions, or likely both. Figures 8,9, and 10 summarize the spending and revenue outlook. Figure 9 illustrates the limited flexibility to effect changes in discretionary spending as mandatory spending and net interest costs eat up an increasing share of the federal budget. Despite the political disputes, Figure 10 shows that individual tax revenues actually increased as a share of GDP after the passage of the 2017 tax law. Figure 11 shows fairly stable tax revenues as a share of GDP compared to increased spending. The White House and Congress will confront important challenges to reduce the federal budget deficit after the 2024 election and replace the expiring 2017 tax law in 2025. However, until after next year’s election, it seems increasingly likely the new higher interest rate regime will likely persist with rising interest costs eating up more of the federal budget.

Figure 8
Federal Outlays by Category (% of GDP)

Source: Congressional Budget Office

Figure 9
Federal Tax Revenues By Category (% of GDP)

Source: Congressional Budget Office

Figure 10
Federal Budget Outlays and Revenues (% of GDP)

Source: Congressional Budget Office

Investment Conclusions

Equity: Among factors, the rapid increase in long-term interest rates, growing geopolitical concerns, and quantitative tightening pulling liquidity out of the financial markets contributed to the equity market’s pull back. In doing so, attractive investment valuations emerged for the 493 stocks that comprise the remainder of the S&P 500 stock index excluding the seven mega- cap tech stocks. Figure 11 illustrates that current valuations for those 493 stocks lie below their historical median levels. Given the current tight financial environment, investors should consider quality companies that possess strong liquid balance sheets and demonstrate sustained high cash returns on invested capital. These companies should be able to meet the current challenging conditions and therefore prove to be attractive long-term investments.

Figure 11
Megacap Tech vs Rest of S&P 500 Index

Source: Goldman Sachs Global Investment Research

Fixed Income: In light of the Fed either reaching or will shortly reach its peak funds rate and the rapid rise of long-term rates, extending fixed income duration seems appealing. If the July Fed rate increase marks the peak, then a rate cut late in the first half of 2024 might be likely. If this scenario unfolds, then new short-term fixed income investments made early next year could potentially face increasing reinvestment risk. The current higher interest rates on Treasury notes and bonds offer an attractive real rate of return for the first time since the Great Financial Crisis. Also, the current higher long-term rates reduce the degree of downside risk from rates increasing when compared to the era of “cheap money” with its much lower long-term rates.

Alternatives: With the changes occurring in the financial industry and markets, alternatives can prove attractive by both providing the diversification benefits of lower correlations with stocks and bonds. In this highly uncertain investment environment, alternative investments can both help manage risk and potentially enhance returns.