The Fed’s latest economic projections show only one rate cut this year, down from three previously, as officials again hold rates steady before moving to ease policy.
What happened?
The U.S. Federal Reserve kept policy unchanged for the seventh consecutive meeting, as expected. It made small changes to the policy statement, now saying there has been “modest further progress” on inflation, rather than “a lack of further progress.”
The accompanying Summary of Economic Projections showed a shift in rate expectations. The median FOMC member now anticipates only one rate cut this year, down from three previously. The total number of cuts expected through the end of 2026 remained unchanged. That move came alongside an upward revision to the near-term inflation outlook and no change to expectations for growth or employment.
In his press conference, Chair Powell continued to signal that the next move will be a rate cut, and that the timing of the first cut will depend on the incoming data. He indicated that, notwithstanding the better recent data, the FOMC still wants to see further improvements before it can be fully confident that inflation is returning sustainably to the 2% target. Powell also indicated that the Fed is watching downside risks to growth, and unexpected weakening in the labor market could support rate cuts.
Economic momentum begins to soften
The first quarter was dominated by strong labor markets and hot inflation, but conditions have moderated in recent months. We continue to anticipate a further deceleration in growth, which should feed through to lower inflation.
On the inflation front, key metrics have shown slow but steady progress since the hot readings at the start of the year. The most recent core CPI data cooled significantly, to an annualized pace of +2.0%. Shelter inflation is still rising too fast, but signs of deceleration have appeared in other areas of core services, and core goods prices continue to fall.
The labor market remains strong overall, with a healthy pace of job creation of around +250,000 per month and steady wage growth. However, the unemployment rate has ticked higher to 4.0%, and other measures increasingly show loosening. The number of job openings fell further, and the private quits rate remains below pre-Covid levels.
Other metrics have slowed as well. The latest retail sales data showed flat spending and indicated contraction when excluding volatile elements like gasoline. First quarter GDP was revised down -0.3pp from the preliminary print to an annualized rate of +1.3% quarter-over-quarter.
Looking ahead, we continue to anticipate a modest slowdown in U.S. and global growth this year. Loosening labor markets and softer wage inflation should eventually translate into further deceleration in price inflation. The path will likely remain uneven, and we still expect core inflation to hold well above the Fed’s 2% target into 2025.
What does this mean for investors?
Even as the Fed moves closer to cutting rates, U.S. bond yields remain near their highest levels of the past 17 years. In our view, today’s elevated yields offer an attractive entry point for municipal bonds. U.S. investors in the highest tax brackets may realize taxable-equivalent yields ranging from 5.65% to 6.70% (depending on the maturity), with even higher levels in states with income taxes.
In the below-investment grade space, high yield municipals are yielding 5.6%, for a 9.5% taxable-equivalent yield. About 75% of the high yield municipal bond index is made up of higher-quality BB rated issues. Default rates for these BB rated munis roughly equal those of BBB rated corporates.
In other areas of fixed income, we see opportunities in select asset-backed securities (ABS) and below-investment grade corporates. Within ABS, consumer and commercial credit performance continues to show signs of stabilizing. Default rates are in line with pre-pandemic levels, with substantially higher yields. Commercial mortgage-backed securities (CMBS) offer substantial reward potential for investors willing to accept the risks facing office and retail properties. One area of interest is the private label CMBS market (where loans in securitized pools are not guaranteed by a government agency or government-sponsored enterprise), which has returned more than 5% year-to-date, making it one of the best-performing fixed income sectors. That said, active management is crucial due to the sector’s idiosyncratic risks.
In the below-investment grade space, floating rate senior loans have returned 4.2% year-to-date, with yields ranging from 7.5%-9.5% (depending on quality). Senior loans offer equity-like potential returns with lower volatility and downside risk. The asset class is well positioned to complement the longer duration nature of the broader fixed income landscape. We generally favor up-in-quality loans, but we also consider select opportunities in lower-quality issues.
In equities, U.S. small caps remain attractively valued relative to large caps, with the forward price-to-earnings (P/E) ratio of the Russell 2000 Index versus the Russell 1000 Index near a 22-year low. Additionally, based on analyst estimates, earnings should grow faster for smaller companies in 2024. This is especially salient because corporate earnings growth has been the primary driver of stock price appreciation over the long run — a trend that should continue as inflation and interest rates gradually normalize.
Publicly listed real estate securities such as real estate investment trusts (REITs) were among the hardest-hit asset classes during this Fed tightening cycle that began in March 2022. Given their elevated use of debt compared to broader equities, REITs declined precipitously (-21%) between mid-April 2022 and the end of October 2023, as measured by the FTSE Nareit All Equity REIT Index. But REITs have historically delivered strong relative returns in steady and declining rate environments.
During the final two months of 2023, with the Fed on pause and market expectations for rate cuts peaking, REITs returned +22%. Meanwhile, despite stable REIT fundamentals and generally favorable valuations, investor allocations to real estate are at the lowest level since the 2008 global financial crisis, according to a recent Bank of America survey of global fund managers. The scope of this underweight could be a potential contrarian signal to add incrementally to this sector.