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Yimin Xu of Cestrian Capital Research on past easing cycles, strong economic data and Fed rate cuts (0:40). Sticky inflation and bond market equilibrium (2:30). Attractive 10-year yields (5:00). This is an abridged conversation from Seeking Alpha’s Investing Experts podcast.
Transcript
Rena Sherbill: Yimin Xu, welcome to Seeking Alpha. You contribute to Seeking Alpha news, you’re on YouTube with Cestrian Capital Research, which by the way, if that sounds familiar, we’ve had Alex King, who runs their Investing Group service on a few times before.
How are you looking at the markets? A lot of talk about the Fed always and particularly recently. How are you looking at things as broad and as specific as you want to get?
Yimin Xu: A lot of investors are worried that strong data means the Fed is not going to cut anytime soon, and therefore that’s bad for the equities market. But actually, historically speaking, and if you look at the past easing cycles, there had been one time in 1995 where the GDP was growing very smoothly. It came down slightly from 1994, but it was still very strong.
The Fed was slightly worried about inflation, which was coming down from high figures in the early 90s, but actually, they were willing to wait for the soft inflation and for – sorry for the soft landing and for the inflation data to come down and cut much later than the market than what you would expect. And what happened was that equity market rallied because a good economy would translate into stronger earnings and it’s not always a bad thing.
When we see aggressive Fed cuts it sometimes means that it’s driven by recessionary fears, which translates to slower growth and slower earnings. That’s not always a good thing for the equities market.
So I think at this point in time, good news is actually good news at this moment. It’s only when the Fed is really actually starting to cut too late and we’re seeing bad data coming our way without the Fed doing something drastic about it that we should begin to worry. So that’s my feel for the macro at the moment. So, actually I’m quite optimistic.
RS: And how would you relate that to what’s going on in the bond market and how you feel investors should be thinking about the bond market and positioned in that part of the market?
YX: So at the beginning of the year, the bond market priced in 7 price cuts, sorry, 7 rate cuts for 2024. And that was way too aggressive, but I actually understood why that was the case. There was actually a rationale for it. And the reason being that if you look at the real interest rate, which is even if the Fed doesn’t do anything, the real interest rate goes up if inflation goes down.
And if the inflation moves towards 2.5%, 2.4% by the end of the year, as the Fed projected in the December FOMC. And if you give or take 1 to 1.5 percentage points for the neutral rate, real neutral rate, that gives us a 4% target in the nominal rate for the market being neutral.
And the effective Fed funds rate today is 5.33%. So, to get to neutral rate, we are actually only 6 cuts away, right? So there is a rationale for it. The market was optimistic that inflation will come down smoothly. We get to the PCE target and the Fed should ease accordingly to get to the neutral rate. But now it’s clear that inflation is a bit stickier and the final bit of inflation always takes a bit longer than the market expects. So, we’re pricing in 4 rate cuts this year.
I actually think 3 to 4 rate cuts is about right, is about the equilibrium. If we go below 3, then that’s probably too few. If we go above 4, that’s probably too many. And that’s only because inflation could be just a bit stickier than what investors expected at the end of last year.
So, I think right now the bond market is in a good equilibrium. I am actually on the margin, I would be a buyer here only because I don’t think inflation would come back strongly like the Fed would think it. And so, in the longer-term, the yield curve should normalize and we should get steady rate cuts in the next two years.
So, on the margin, I think buying bonds here is not bad. It’s not bad. And I don’t think we can get to just 1 or 2 cuts for this year, and I think currently 3 cuts to 4 cuts this year is about fair, yeah.
RS: And in terms of the treasury market, if you feel like there’s worthy investments there for investors, any thoughts there?
YX: I think for a long time, everyone’s been really worried that the timing of the QT clashing with the Treasury issuances to boost the Treasury General Accounts, i.e. The U.S. Treasury holding money would actually dampen the treasury demand, which actually had been the case for most part of last year.
And if you look at every time when the Treasury does the bond issuance, the bond yields always go up because the Fed is not really a buyer on the margin anymore, compared to the previous two years, but actually I think now, because the investors understand the way the path forward is the easing cycle and the 10-year at 4.25% today is still relatively attractive given where the yields will go in the future.
So, I do think the longer-term yield – I think the yield curve is quite – offers quite good value at the moment if you’re a long-term investor.
And what’s also interesting is that a lot of banks had been burned on the way up in the rate cycle. What I mean is that, if you look at the regional banking crisis last year, the regional banks locked in 10-year yields at, let’s say, 2% and the Fed hiked aggressively, and the bond portfolios essentially dropped, right, in terms of value. And Silicon Valley Bank (OTC:SIVBQ) has gone bust, but even Bank of America (BAC) has suffered a lot in terms of the portfolio value.
Now, on the way down, this could be a good thing for banks who have held a lot of bonds when they bought the bonds two years ago, holding to maturity. Now, the valuations are going up as we cut interest rate and the bond prices go up.
So I think on the margin, I’m a buyer here. I think across the curve, the curve is not, it’s obviously inverted right now, but it’s also kind of flat. And I think the 10-year, I would prefer the 10-year to the shorter-term Treasuries – just because we are, the 10-year still pricing in a very high relatively high steady inflation not going forward, and a fairly high neutral rate on top of that. So, I think that could be, you know that could offer better value than the short-term side of the yield curve.
