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Why the bond market should expect more volatility ahead

Federal Reserve Chair Jerome Powell is testifying for the second day before Congress as the US continues to grapple with inflationary pressures. Tocqueville Asset Management portfolio manager John Petrides and WisdomTree head of fixed income Strategy Kevin Flanagan join Catalysts to break down the market reaction to Powell's comments and how investors should best position their portfolios amid the current economic backdrop.

Flanagan explains that the Fed is in a precarious balancing act when it comes to initiating a rate cut: "The Fed does not want to make a mistake here one way or the other, right? They don't want to be on hold too long, but they don't want to cut rates too soon. So it is kind of a tightrope that Powell and company are walking." He explains that the bond market will experience some volatility as the Fed continues to weigh the timing of its first rate cut.

Petrides notes that overall market volatility has been "strangely quiet" recently. However, if volatility were to increase, he believes the Fed will likely change its language to be more market-friendly. He points to gold (GC=F) as a smart investment amid economic and geopolitical uncertainty, explaining, "We think there's way too much uncertainty with the amount of debt the US has on the balance sheet. Gold typically does well when interest rates come down, so if the Fed is in the process of starting to ease, that will benefit gold."

For more expert insight and the latest market action, click here to watch this full episode of Catalysts.

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This post was written by Melanie Riehl

Video transcript

But first coming up here Fed chair Jerome Powell is speaking right now before the House Banking Committee will be looking for headlines here as they come in.

But we know yesterday some of the key drivers of his commentary and therefore the market movements were some of his comments about inflation cooling sounding potentially a little bit more dovish for the market moving forward.

Let's take a listen to what he had to say.

If we loosen policy too late or too little, we could, we could hurt economic activity if we loosen policy too much or too soon, then we could undermine the progress on inflation.

But how much emphasis should markets be putting on the Feds path forward?

Joining us now to discuss this, we've got John Petrini is a portfolio manager from Taco Asset Management.

We've also got Kevin Flanagan, head of fixed income strategy at Wisdom Tree.

Thank you both for joining us and thank you for being in studio.

We appreciate it.

I I do want to start with you because you just heard that sound bite from fed chair Jerome Powell did any of his commentary move the needle for you at all.

Was it more of the same?

I think the fed has been very cautious of not wanting to repeat 19 seventies fed policy mistakes of stop and go.

Right.

So clearly, there's more conviction and I think a lead up to the Jackson Hole meeting in August where the fed will probably start talking about cutting 25 basis points or something along those lines.

So that's a really good sign, I think from that perspective and those that are still convinced the fed is going to raise rates that's off the table for at least the next year.

And Kevin when it comes to what has really been moving the bond market, obviously, lots of focus here on inflation and exactly what we have heard.

Uh Jerome Powell say and kind of the change in tune almost just in terms of the also a little bit of worry about what's been going on within the labor market.

But Kevin I'm curious from your perspective, what's been the biggest driver of yields when it comes to Fed and commentary and really what investors should be focused on?

Well, I think your point is very well taken that they're, they're back to the dual mandate.

Uh The whole focus had been inflation, inflation, inflation.

And I think Powell pretty much laid it out yesterday that the risks are now balanced and that he is seeing some cooling in activity in the labor markets.

I mean, jobless claims are still though 100,000 below where they normally are before a recession, even the pre COVID 40 year average.

So it's not, it's like it's weak or falling off the cliff.

And I think that's what POW is trying to do is to strike a balance here with respect to policy, going forward to the point.

Once again being well taken, the fed does not want to make a mistake here one way or the other.

Right.

They don't want to be on, on hold too long, but they don't want to cut rates too soon.

So it is kind of a tight rope that pal and company are walking and that's what the bond market is trying to figure out and why we're going to continue to see volatility.

A highly data dependent fed, highly data dependent bond market that equals volatility.

Kevin, do you think we're going to push back up against that four or five level in the 10 year?

Yeah, you know, I I would say 4.5 is kind of an equilibrium level plus or minus, say 2030 basis points.

So 420 to 470 some people might say, hey, you can drive a truck through that, but back to my point before, that's where we're at at this stage of the game.

So I if the numbers continue to come in as they have you open the door for a September rate cut, but remember this isn't gonna be like the rate hike cycle.

This isn't gonna be, you know, every meeting, it's gonna be a little bit more choppy.

25 here, 25 there, John.

I know that you say on fed rate cuts.

Who cares?

Which of course, what else would we talk about if we didn't get to digest this and dissected every single day?

But I'm curious if you think that the fed cares about what the market is doing, given some of the frothiness that we're seeing and the kind of idea that there's this unofficial third mandate for them to make sure that there's not a market.

The Fed will definitely say they don't care what the market thinks.

And I think the fact that volatility has been so quiet, like strangely quiet, the VICS is really, really low that the FED is not overly concerned that they're comfortable with where their language is.

If we saw volatility pick up and the Vics get higher and you see more of a sell off in the stock market, I think the FED would be definitely more market friendly in terms of its language.

So John, how should investors be thinking about positioning then just given so much of that uncertainty, we owned a position in gold for the clients that we managed for a very long time.

We increased it in January of 2023 and we still maintain a high level position of gold for our clients.

We think there's way too many too much uncertainty with the amount of debt the US has on the balance sheet.

Gold typically does well when interest rates come down.

So if the FED is in the process of starting to ease that will benefit gold.

And again, we think the fiscal and the deficit and the debt situation in the US is way too uncertain.

Let's not forget that geopolitical and political risk globally is a big issue that again, with the VICS being so quiet.

For me, it's a red flag that, that the market seems overly myopic on just what the fed is doing.

Well, it's interesting too, given what we're seeing, not only with equities but also in terms of yield.

So Kevin, I want to go to you on that particularly in relation to what we're seeing heading into the election come November 5th, we saw that yields fell off the back of the debate.

Do you anticipate politics continuing to drive what we're seeing in the yield space?

No, not really.

I, I do think, you know, from time to time you could see it on a daily basis in terms of trading activity.

I think overall it's the fed that that's, that's the name of the game here as you were just, you were just talking about before and, and what is this rate cut cycle going to look like we're trying to figure that out?

And I think when we're looking at the shape of the yield curve, I think that's important as well.

It's still inverted, it could un invert maybe sometime next year per se.

And that's why we've been talking about bar belling strategy within the fixed income arena trying to take advantage of that inverted curve, but also having something a little bit moving out, maybe closer to core duration in case things do get a little bit sloppy on the economic side, John, when it comes to some of that risk taking that we have seen, we certainly do see this appetite for risk fly out in the market.

And I think that that is something that seems to be a theme here as of late.

Could that lead to, I guess, are, are we starting to see excessive risk taking?

And what exactly does that then signal for?

I mean, I think we're gonna, it's gonna be important to see when the banks report earnings where risk is being taken.

It's going to be interesting to see this upcoming earnings season if the consumer and industrial start rolling over.

But that's the problem though when, when volatility gets is quiet, right?

You've had a rally, you have a very strong stock market since Halloween basically of 2023.

The S and P has only been down one month for this entire year.

People get very complacent and comfortable and it leads them to take on more risk.

You see leverage ratios going up, you know, we had the, the game stop meme craze, get back in the headlines again.

So spreads, I don't want to step on Kevin's toes from the fixed income side, but spreads are really tight from a high yield standpoint.

The treasuries, which means investors are taking on more credit risk to pick up just a little bit more in income.

And those are some signs that, you know, maybe risk tolerance are getting stretched a little bit too far to pick up some return.

Those are things that my antennas are up for, for sure.

Is that new way to position conservatively just going all in even more on large caps, not necessarily large cap.

I think there's value to be had.

International stocks are trading developed country, international trading at a big discount to the US.

Look, it's no surprise.

The US large cap tech is the most crowded trade, maybe in the history of my career.

Everybody knows the whole world for the past seven years has been in US large cap tech growth, right?

And every else value international small cap has created a huge discount.

So I think there are value there's value to be had in other parts of the market to compensate for a position that basically everybody owns.

And if you don't own it individually, you probably own it somewhere in a mutual fund or an ETF somewhere within your portfolio.

So there's diversification to be had in other parts of the market for sure.

All right, John.

Petrides and Kevin Flanagan.

Thanks to you both for joining us here today.