Amid cooling inflation data, heated AI debt financing, and market repricing of the Federal Reserve's path, DoubleLine Deputy CIO Jeffrey Sherman stated that the bond market has already completed part of the tightening work ahead of the Fed.
On July 17th, in the latest episode of DoubleLine's web series "Sherman Says," Deputy Chief Investment Officer Jeffrey Sherman, strategist Ryan Kimmel, and client relationship manager Nick Dalgetty discussed the Federal Reserve, inflation, the fixed income market, AI-related debt financing, and private credit risks.
Market's Core Question: Will the New Fed Chair Turn Dovish?
The core question the market is most focused on is: Will the new Fed Chair, Waller, actually "turn dovish"? Can cooling inflation justify rate cuts? And has the bond market already done some of the Fed's tightening in advance? Sherman's answer was quite direct: the market previously bet that Waller was a "dove in hawk's clothing," but from the current situation, this trading logic is unraveling.
He said: "I have appreciated Chairman Waller's comments so far. He's making a lot of sense. We need to fight inflation. Yes, we need to fight inflation." However, he also emphasized that the key is not rhetoric, but data and market pricing: "Ultimately it's going to come down to the data."
The Bond Market Has Done the Job for the Fed
Sherman pointed out that, judging from federal funds rate forward pricing, the bond market has repeatedly led Fed actions in the past. The most important current change is that the market is no longer continuously betting on rate cuts as it did over the past three years, but instead is starting to reflect the possibility of a rate hike within the next year.
He said: "Notice what's happened since the Fed policy peaked. The market heard Powell announce the end of hikes and started pricing in cuts, but the cuts didn't really materialize." What's different now is: "The market seems to be saying: maybe the Fed hikes sometime in the next 12 months."
In Sherman's view, this means Waller may not need to act immediately right now because market rates have already risen, and the yield curve has repriced. He stated: "What you're seeing now is the market has actually done the work for the Fed — you have an upward sloping curve, and the policy rate is below every other rate on the curve. So, Chairman Waller may not need to do anything for now, he can sit back and wait."
For those betting on a September rate hike, Sherman believes the bar is quite high. He said it would take "a lot of data" to force the Fed into such a decision, especially with an election approaching and political pressure present.
His summary was: "The bond market is doing its job. It's sniffing the data."
Inflation Data Cools, But Waller Remains Cautious
On inflation, Ryan Kimmel noted that June CPI data was significantly weaker than expected, showing easing price pressures.
He said: "The June CPI print was much weaker than expected. On a month-over-month basis, it was down 40 basis points overall. Even core CPI, stripping out volatile food and energy, was negative unrounded — I think that's the first negative month-over-month print since 2020."
Kimmel further explained that core CPI unrounded was "negative 2 basis points," core goods prices were negative month-over-month, and core services slowed to nearly flat at about "positive 3 basis points." The inflation swap market also cooled: "After that print, the inflation swap market also sold off pretty hard. The one-year inflation rate dipped below 2% for the first time in quite a while."
However, Kimmel cautioned: "You can't extrapolate one month's data."
Sherman added that Waller also remained cautious during his congressional testimony. He relayed that when Waller was asked about the latest inflation data, he "basically just said it's one data point, we shouldn't get too optimistic right now."
Why Is Core PCE More Stubborn? AI Software Demand and Stock Market Gains Are Pushing It Higher
Compared to CPI, core PCE's performance is more troubling for the Fed.
Kimmel pointed out that core PCE growth is still accelerating, with some special factors at play, including software spending and portfolio management fees. He said: "Software is a bigger influence — AI demand is really pushing up core PCE, making it grow significantly relative to core CPI."
Additionally, "portfolio services or portfolio management fees, it's directly tied to, driven by, stock prices. So, when stock prices go up, that component of PCE also performs stronger."
Kimmel also mentioned that the Bureau of Economic Analysis will recalibrate PCE data in September, updating the measurement methodology for the software component and portfolio management fees, which "could actually shave 20 to 30 basis points off the annual run rate from what's expected."
Wage Pressures Recede, But Consumer Sustainability Remains in Question
Regarding the labor market, Kimmel believes wage growth is returning to pre-pandemic levels, and labor supply and demand are more balanced than in 2022.
He said: "Wages are reverting back to pre-pandemic levels. The labor market was exceptionally tight in 2022, demand far exceeding supply. That's completely eased now, the labor market is more balanced."
This means the risk of a wage-price spiral is not apparent. But Sherman reminded that the average consumer may not feel optimistic, as pressures from insurance, gasoline, and other prices are more direct.
He said: "Most people would say wage growth hasn't kept up with inflation. And it's true." On economic activity, Sherman noted that PMI data still shows signs of expansion, but one must distinguish between "activity" and "growth." He said: "Anything above 50 means more positive responses than negative." But manufacturing is less than 15% of the economy; services are key.
On consumption, Kimmel pointed out that real consumer spending year-over-year remains above 2%, but real wages are basically stagnant. The divergence between the two raises sustainability questions. He said: "If real spending is well above income, it's an open question."
Sherman added that unless households draw down savings, it's hard to maintain current consumption strength; meanwhile, the wealth effect from rising stock, cryptocurrency, and real estate markets is also supporting consumption.
He stated: "Unless people start dipping into savings, it's hard to maintain the current level of consumption, and we've actually seen that happen."
Fixed Income Market: High-Quality Assets Finally 'Have Yield', But Above 6% Requires Risk
Regarding the fixed income market, the DoubleLine team believes that overall performance has been relatively stable this year against the backdrop of rising yields, but different assets have diverged significantly.
Kimmel said CLOs and floating-rate notes have performed relatively well, with CLO returns around 2.5% to 2.9% year-to-date, and high-quality bank loan returns around 2.6%. But CCC-rated loans have performed worst, with the software sector under particular pressure.
Sherman pointed out that the U.S. Treasury market does not subscribe to the narrative of significantly lower rates. He said: "The bond market doesn't seem to be buying the story that rates are going to come down meaningfully."
He also mentioned that if the 10-year Treasury yield breaks above about 5.25%, other market dynamics could change.
For high-quality fixed income assets, Sherman believes the positive side is that yield has returned. He said: "The positive is we finally have some yield."
Specifically, he mentioned that high-quality corporate bond yields are around 5% to 5.5%, residential mortgage-related asset yields around 5.3% to 5.8%, high-quality CMBS around 5.1%, and high-rated CLOs also around 5.1%. But he cautioned: "If you want assets yielding above 6%, you have to take on some risk."
Kimmel added that from a relative value perspective, sectors like agency MBS, high-rated CMBS, and AAA CLOs are receiving more attention. He called agency MBS "one of the most attractive sectors to allocate to if you're looking for defensive exposure."
However, Sherman supplemented that investment-grade corporate bonds, emerging market sovereign debt, etc., are already at "the tightest levels in nearly a decade," and investors need to be more nuanced in searching for relative value.
AI Debt Financing Scrutinized, Private Credit 'Investment-Grade' Narrative Questioned
In this episode, Sherman expressed clear wariness towards AI-related debt financing and the private credit market.
He said the market has started paying attention to the debt financing pressure behind AI expansion, and the bond market will "set the tone" for this. Sherman stated: "We talk about AI and the debt financing that comes with it, it's become a hot topic. The market is starting to pay attention to this, the bond market will set the tone for it."
He particularly questioned the narrative of some private credit products packaging high yield as "investment-grade." He said bluntly: "If someone's pitching you a bond yielding 10% or 11% and calling it investment-grade because it's private or it's got some magic to it — the key is, at least from a public market perspective, the risk isn't low."
The high-yield market is already reflecting stress in some lower-rated assets. Sherman mentioned that CCC-rated high-yield bond yields have reached about 14%, and loan market yields are as high as about 16%. But he cautioned: "Sounds great, but the question is how much principal you get back is a different story."
He also pointed out that the BB and CCC markets have recently decoupled, and historically such divergence often means one side needs to "catch up" to the other.
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