This title is a bit misleading. I’m not rethinking my interest rate outlook. Rather, I want to convince investors to rethink what higher interest rates can mean for investment returns. Core to my outlook is the expectation that interest rates are renormalizing at a higher level, an outlook that investors often interpret as challenge but I argue should be reframed as positive. I look at the reasons to be optimistic, and why we may be entering a golden age of alternatives.
Market expectations around interest rates have shifted significantly since the start of the year, but my own interest rate outlook remains unchanged. I think of the outlook from three angles: Short-term interest rates, long-term interest rates and the impact on investing. Because the short-term interest rate outlook is so dominated by the Fed funds rate, it is critical to quickly check in on the latest macro news driving policy decisions.
Solid growth, strong labor market. In January, we closed out 2023 GDP growth with a Q4 report that reflected an economy firing on all cylinders, and clocked 3.1% Q4/Q4 for the year, well above potential growth. 2024 kicked off with strong labor market data, including a blowout 353,000 jobs gained in January. The unemployment rate was 3.7%, and has now been below 4% for two years, something not seen since the 1950s. While January retail sales data reflected some pullback (some of which may be weather-related), it is difficult to be too worried about household spending which ultimately drives the business cycle when the labor market is providing a strong foundation. It is worth pointing out the Atlanta Fed’s GDPNow model estimates Q1 GDP growth of 3.2%.
Inflation is proving stubborn. Inflation data has not cooperated with the market’s narrative that the Fed will have room to aggressively cut rates, and upside surprises in a variety of wage and price indicators has forced markets to walk back rate cut hopes. Consumer prices (CPI) rose 0.3% m/m in January, when a 0.2% gain was expected. Excluding food and energy, core CPI also beat consensus with a 0.4% m/m gain. The Fed has focused on core services excluding shelter (markets have dubbed this “supercore”), and recently that measure has reaccelerated. Indeed in January this smaller slice rose 0.7% m/m, the fastest gain since September 2022. Wage inflation has also stopped falling, a combination that will keep the Fed uneasy. Average hourly earnings were higher than expected in January, and edged up to 4.5% y/y, a pace of wage inflation not consistent with the Fed’s 2% inflation target absent a miraculous secular boom in productivity. Producer prices jumped in January, as well. I have been saying for some time the disinflationary road back to 2% will be bumpy and uneven. We hit a serious speed bump at the start of the year.
Expect surgical rate cuts in the second half of 2024. At the start of the year, markets were pricing in seven rate cuts in 2024, starting at the March 20 FOMC meeting. I wrote in my 10 for ’24 this was wholly unrealistic without a sharp economic slowdown. Following the inflation data and a loud accompaniment of Fed rhetoric, markets now expect three to four rate cuts, more closely in line with the December dot plot that included three rate cuts.
It is important to remember the Fed often gets its own forecasts wrong or isn’t able to accomplish its stated expectations for policy changes. My colleague Troy Gayeski described this beautifully by drawing a corollary to the rate hike cycle following the Global Financial Crisis (GFC): At that time, the Fed signaled as early as mid-2014 through the dot plot it expected to raise rates four times in 2015. And yet market conditions and data did not clear the runway for liftoff until the end of 2015, when the Fed raised rates only once (and waited a full year to raise rates again). This is feeling a little like the mirror image. The rate hike cycle is almost certainly over, and the Fed wants to cut rates – but the “when” and the “how much” are still highly uncertain. I pencil in two to three surgical rate cuts by the end of the year, but like the experience of ten years ago, the Fed’s plans may be derailed by either the markets or the data, or both. The phrase surgical rate cuts is intentional: Without an economic slowdown, expect rate cuts to be done carefully and under the right conditions. At present, the lack of a pressing economic impetus for rate cuts is affording the Fed cover to take their time in assessing the inflation data – time we expect they will utilize.
10-year Treasury may re-test 5%. Short-term rates have likely peaked for this cycle, but my expectation is that long-term rates are likely to test higher. I’ll be honest, given how strong the data has been, I’m surprised the 10-year has been stuck between 4.20-4.35% for much of February. Particular to long-term interest rates are long-run expectations around inflation, which I think are too complacent, and long-run expectations around growth, which may be too low. And supply-side dynamics will lift long-term yields higher. Stepping back, the yield curve remains inverted. The 3M-10Y spread is rate spread around -110 bps, and the 2Y-10Y spread is around -40bps. If markets are convinced the economy will remain strong and avoid a recession – as equity earnings forecasts would imply – then at some point the yield curve should normalize with a positive slope. It makes sense this would occur with a sort of twist with short-term rates coming down somewhat and long-term rates moving somewhat higher. At the end of the day, this could be a positive outcome. It would certainly relieve some of the interest margin squeeze on the banking sector.
Higher interest rates have been painful for many sectors of the economy and markets. After more than a decade of interest rates being at or close to zero, the speed at which rates rose in 2022-2023 made for a particularly wrenching adjustment. When the Fed raised rates 525 bps to the highest rate in 20 years, it did it in just 16 months. The 10-year Treasury started 2023 at 1.50% and hit 5.00% (the highest in 15 years) in October, just 10 months later. Interest rates sensitive sectors of the economy and markets have been hit hard, including real estate and M&A activity. And yet, a wider lens clearly showed long periods when interest rates were at current levels (or higher) with robust activity.
Embracing alternatives after TINA. The 2010s will likely go down as the TINA regime. With interest rates so low, traditional fixed income became virtually un-investable, leading to the There Is No Alternative (TINA) to equities mantra. Today, there is a rich spectrum of investments that may not have looked attractive for decades. This is the powerful positive of core interest rates renormalizing! Some – like private credit and private real estate lending – were simply not available 20 years ago. We wrote in our 2024 market outlook about opportunities in the market when many traditional investments are expensive compared to historic valuations. We are now seeing potential for double digit returns in high yield, leveraged loans, and a spectrum of private credit and private equity solutions that offer compelling alternatives to equities.
This is where I am happy to end on a positive note. The macro backdrop is sound and I expect growth of 1.5-2.0% this year, a solid growth outcome that should support healthy corporate fundamentals. For asset allocators, there is finally an interesting set of alternatives to compliment equities in a portfolio. This is not to say that a higher-rate regime is an unalloyed positive – there will be weak companies and borrowers that were kept afloat by the ZIRP era who will falter assuming rates remain elevated, creating pockets of new challenges for investors. However, we view the end of rock-bottom interest rates as a healthy development for markets and the economy overall. Ultimately, investors should welcome this new rate environment – one in which alternatives can add meaningfully to income, growth and diversification.
