Inflation: ‘The Fed still has some work to do,’ Strategas Managing Director

Strategas Managing Director Tom Titzouris joins Yahoo Finance Live to provide insight on how to best position fixed-income investments, investor sentiment, the Fed’s inflation print, and the latest banking sector woes.

Video Transcript

- Now all eyes are on the fed for their next move. And joining me now is Tom Tizouris, managing director head of fixed income research at Strategas, a Baird company Tom, thank you for being here today. Just kind of laying out where you see the markets right now. We've had this incredible bond market volatility which has ebbed a bit. But we saw in March, over the month of March, rates largely crash and kind of settle down to where they the levels where they are now. What's your picture look like?

TOM TITZOURIS: Yeah, well, there's been two narratives, two stories in 2023. The first one to start the year was that inflation was sticky. It was coming in. It was coming down, but it was coming in at levels that were still well above what the Fed would consider comfortable. And we just got another inflation print today. And yes, it's come down a little bit, but it's still well above a level that we would call comfortable, about a 4.6%.

And so because inflation was really clearly going to be sticky throughout this year, you saw the bond market starting to sell off again, and you saw yields pushing higher. And in particular, you saw short term yields in the one to two to three-year bucket really drastically pushing higher, upwards of 5% not too long ago.

Then all of a sudden, as your guests have talked about, the issues in the banking sector, and that completely dwarfed the story of inflation, and you saw yields drastically dropping. And you saw at one point in time, two-year yields dropped about 130 basis points in about two weeks. Just really, an astronomical drop for this era that we're in. And now, you're seeing two-year yields backing back up again about 30 basis points as the banking sector fears begin to ease a bit.

So those two themes have been kind of competing off each other. And for now, as we sit here at the end of the quarter, we're looking at more or less the market kind of settling back into this notion of sticky inflation. And the Fed still has some work to do, but we don't really know just yet how much that work is and what they're going to do.

Our base case right now is that the Fed does pause here with the Fed funds rate at 5%, and they do continue though to reduce their balance sheet. And that means yield volatility is probably going to remain elevated for at least another quarter, if not the entirety of this year.

Thinking about corporate credit spreads. A lot of times, credit leads the equities markets. And we saw some spreads widened recently as a result of the banking sector troubles. But just overall, let's leave the banks out of this, especially the regional banks. How are corporate credit spreads looking in the US, I guess, compared to where they were about a month ago?

Yeah. So right now, for example, in the investment grade corporate space, you're looking at spreads of about 140 basis points. And that is maybe 20 basis points below where we were a week and a half ago, two weeks ago. And so we've come down. But that's also about 40 basis points below where we were at the peak of October of last year, about 180. So spreads have dipped lower.

And the primary reason why you've seen spreads dip lower this year is that the market does seem to be buying into this view that a soft landing in the us is still something that can be achieved. If the market believed a recession were imminent, you'd see investment grade credit spreads about 2%, 200 basis points. So we're well off of those levels that would signal a recession.

And I do think that even if the US does enter a recession, it's not likely to enter it this quarter or next quarter, and that's likely to come later in the year. So there's some time, but we do expect spreads are going to widen out, rise this year, and eventually move back to that 180 to 200 level that we're at last October.

- You mentioned the two year treasury note and the incredible volatility. It's the most volatility that we've seen going back 40 years. You have to go back to the 1980s basically. A little bit before that chart you see on your screen. Just as a big picture question, are you dusting off playbooks from bygone eras? I mean, I was alive during the era. I certainly wasn't trading.

And I'm just wondering, most people are fighting the last crisis. Most people's memories are kind of imprinted by their previous bear market experience. And given the fact that we don't have a lot of people who have been trading fixed income for the last 40 years, how is the industry responding to this?

TOM TITZOURIS: Well, right now, I would say the industry has not responded and has not been proactive in anticipating the type of yield volatility that we're seeing this year. And that's a great analogy, dusting off the playbook from the 1980s per se because what we're dealing with now, elevated yield volatility, because inflation is sticky at levels that are uncomfortable for consumers and the fed, that means asset liability management at banks, at hedge funds, and insurance companies. It all matters again.

And so you're starting to see a replay of some of the stress we saw in the banking sector in the '80s, where asset liability management, or duration gaps, or interest rate mismanagement began to cause bank failures. I think we're seeing that again. And this is really more a consequence, I think, of the fact that people underestimated how sticky inflation was going to be and how quickly it was going to rise from stimulus that was put in place a year and a half, two years ago, and from the fed being slow to raise rates.

And once that inflation became embedded in the system, yields were going to spike, and yields we're going to spike in a very volatile and very difficult to hedge way, and that's what we're seeing now. So I do think we have to pull back and bring out that playbook from the '80s. Unfortunately, some institutions did not do that in enough time.