The Federal Reserve was successfully able to remove the term "patience" from its post meeting statement last week and, at the same time, eased market fears of an impatient Fed. The week or so leading up to the Fed meeting had seen increased calls for the Fed to be slow in raising interest rates, from Ray Dalio at Bridgewater to Jeff Gundlach at DoubleLine. I am in agreement that the Fed should be very deliberate about when and how much it raises rates. The downside risks from too much tightening far exceed the risk from being slow.
The Fed was successful in achieving its goal of maximum flexibility while still removing "patience" because of two key factors. First, by stating that employment has room to improve from its current level. Second, by reducing its forward expectation of the Fed Funds rate in the "dot plot" from 1.125% at year end to 0.625%. As a result, the market has interpreted the Fed as being more dovish, leading to the decline in interest rates, increase in the stock market, and depreciation of the U.S. Dollar that we have seen since the meeting ended.
So where do we go from here? I expect the markets will be very data-dependent for the next few months, with large day-to-day or week-to-week volatility. It is difficult to create "alpha" in this type of short-term, choppy trading action because no clear trend exists. In this environment, it is difficult to reposition a portfolio to take advantage of these short-term opportunities. Additionally, low liquidity in most markets makes it costly to execute large trades and even costlier to reverse those trades if it becomes necessary, given the swiftness of market moves. With that said, opportunities do exist to generate solid returns, and pockets of long-term value still can be found.
On the fixed income side, while we have been placing less emphasis on high yield corporates and agency residential real estate-backed bonds, we continue to see value in Collateralized Loan Obligations (CLOs) and multifamily housing backed bonds. If you haven't read last week’s Chart of the Week by Mark Heppenstall, take a look, as it explains why residential mortgages are overvalued.
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