Stairs or the elevator?

Source: Reddit

By Guest Blogger Scott Booth

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A common saying in finance is that “markets take the stairs up and the elevator down”, meaning that advances are typically gradual and market declines are sudden.

The chart below illustrates the path of the Fed Funds rate over the last couple decades, it certainly seems appropriate that this adage can be applied to interest rate policy as well. The last three times we’ve gone through periods of significant rate cuts, those have occurred during periods of crisis and central bankers have taken the elevator, with rate reductions that were swift and substantial.

Fed Funds Rate

Source: Federal Reserve Bank of St. Louis, Turner Investments, September 19, 2024

Mr. Powell and his colleagues on the Federal Reserve board have now joined a growing cadre of central bank honchos boarding the monetary-policy-easing train, with our southern neighbours starting out with a sizeable 50 bps cut on Wednesday.

Fixed Income 101:

• Rates go up, bond prices go down and vice-versa
• Short-term bond prices move around much less than long-term bond prices
• During periods of rising rates, short-term bonds and cash are the places to be.
• Long-term bonds will generate better returns when rates are coming down.

While central banks are just recently embarking on policy easing, longer-term bond yields, illustrated here using the chart of the 10-year Government of Canada bond, peaked almost a year ago around the 4.25% mark. From a peak at the end of Q3/23, the 10-year yield proceeded to plunge in the fourth quarter as equity markets rallied strongly, fueled by the belief that inflation was done, rate cuts were coming, recession would be avoided, labour markets would hang in and companies could still make money in the current environment.

A little AI driven euphoria didn’t hurt either.

Yields subsequently rebounded through the spring, rising on a resurgence of inflation concerns before reaching a recent peak in early-May. The trend has been lower since as markets became more convinced inflation was contained and rate-cuts were coming. We took steps to extend the duration of portfolios near each of these peaks and highlighted the opportunity to extend term around this time last year.

Government of Canada 10-year Bond Yield

Source: FactSet Inc., Turner Investments, September 19, 2024

It has been a great run for bonds over the last year. Several of the ETF holdings we employ to get bond exposure have generated total returns in the low to mid-teens over the last twelve months. Not bad for boring bonds. Falling rates and narrowing credit spreads have provided a fertile environment for their performance.

Preferred shares have been on an absolute tear as well, with a number of ETFs containing theses assets having generated total returns exceeding 30% over the last 12 months. Declining rates, dividend increases through reset, tightening credit spreads and redemptions have all been contributing factors to a stellar run.

Rate sensitive assets like REITs and dividend stocks have taken a little longer to show signs of life but have really caught a bid in recent months as conviction that rates are headed lower has taken hold and been reflected in the performance of these assets.

REITS on the Rise

Source: FactSet Inc., Turner Investments, September 19, 2024

One would suspect Amazon’s recent announcement of their expectation to see butts back in chairs in offices five days a week might help with the outlook for office space, which has obviously been dismal in the wake of covid. That move back from the bunny patch isn’t going to be pleasant.

During this cycle, short-term rates took the elevator up, climbing faster than they have at any point since the early 80s as policy makers endeavoured to douse the flames of the inflation which they played a significant role in igniting with their response to Covid-19 (extended period of near-zero rates and massive quantitative easing).

Efforts to stem runaway inflation seem to have been successful, as that cat looks to be back in the bag, and so now the focus now turns to labour markets, which, while struggling more of late, aren’t exhibiting levels of unemployment that are too elevated compared to historic norms.

So, will it be the stairs or the elevator on the way down as central bankers try to dial in a soft landing?

It seems fair to expect the path down will differ from the last few iterations. For one, it doesn’t look like there is a crisis to kick it off. Cuts here are likely to be front-end-loaded as central banks held policy rates at elevated levels until they were convinced that inflation was truly yesterday’s news, leaving them a little behind the curve initiating cuts as labour market stresses are starting to appear. Sizeable cuts will come near-term and then we’ll be back in data-dependent wait and see territory regarding the path forward from there. CB’s are in normalization mode…not stimulation mode.

Steep steps down to the landing on the 2nd or 3rd floor seems to be the likely trajectory for now. The elevator is always an option should a crisis materialize.

Scott Booth, CFA, is a seasoned financial advisor and licensed portfolio manager. Over the past 18 years he has worked in the capital markets as an analyst, trader and advisor with major banks and now with Turner Investments.

Source: https://www.greaterfool.ca/2024/09/20/stairs-or-the-elevator/