The Fed Sends a Clear Message

Our Chief Fixed Income Strategist explains why the Federal Reserve’s most recent meeting was so consequential, and the likeliest path ahead for interest rates.

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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley’s Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, I'll be talking about last week’s FOMC meeting and its impact on fixed income markets.

It's Thursday, May 9th at 1pm in New York.

Last week’s Fed meeting was consequential. It had a clear and unambiguous messaging about the path ahead for Fed’s monetary policy. Fed’s next move in policy rate is unlikely to be a hike. The Fed’s focus now is on how long the current target range for the fed funds rate will be maintained; and the next move, whenever it happens, is likely a cut. Importantly, the FOMC’s decision was unanimous and their statement maintained an overall easing bias.

In the aftermath of recent upside surprises to inflation and the reaction in the rates market, many market participants, yours truly included, were apprehensive that the FOMC’s tone might be overtly hawkish. Turns out, that was not the case. By setting a very high bar for the next move to be a hike, the Fed’s message has meaningfully narrowed the distribution of outcomes for policy rates, at least in 2024 As our economists led by Ellen Zentner note, the two likely policy outcomes now are keeping the rates on hold or cutting.

Given the prospect that policy rates may remain in the current target range, the negative carry of an inverted yield curve keeps us from pounding the table to move to outright long in duration, although the direction of travel does suggest that. We would note that Guneet Dhingra, our head of US interest rate strategy, sees better risk/reward in duration longs through 3 month 10 year receivers than in the very crowded curve steepener trade. In general, spread products in fixed income – agency MBS, corporate credit and securitized credit – stand to benefit the most from this notably less hawkish messaging, in our view.

As Jay Bacow, our head of agency MBS strategy, observes, the backdrop in which tail risks of higher policy rates are much more remote than they were before the FOMC meeting is supportive for agency MBS. At current valuations, agency MBS offers an attractive expression for investors seeking to play for lower interest rates, lower interest rate volatility or both.

Their high all-in yields have bolstered strong inflows and sustained demand for corporate credit across a wide range of investor types. If policy rates remain in the current range, we expect the demand for corporate credit to accelerate. If policy rates stay in the current range or go lower, pressures on interest coverage are unlikely to get worse going forward. Given their high single-digit all-in yields, we see an attractive risk/reward calculus favoring leveraged loans. We like expressing this view directly in loans as well as in securitized credit through CLO tranches.

In sum, the message from the Fed was clear and unambiguous. The policy rate path ahead is for rates to remain in the current range or decline, and the bar for the next move to be a hike is very high. This bodes well for a wide range of instruments in fixed income.

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