Entering a new rate environment

Welcome to the first episode of the Treasury Markets Minute, where our experts break down the latest financial market developments and offer insights that can impact your portfolios. I'm Heather Froehlich, National Sales Manager for State Treasury Pools, and today I'm delighted to be joined by Paige Wilhelm, Senior Portfolio Manager at Federated Hermes who has vast experience in managing short term portfolios.

Today's discussion centers around an important topic: navigating declining rate environments. With the recent move by the Fed and growing consensus that additional rate cuts could be on the horizon, we want to explore how LGIPs can leverage this environment.

So, Paige, I'd like to start by asking: What are the key advantages of being in an investment pool when rates are on the decline?

Paige: A local government investment pools yield will lag the rates of direct market securities in a declining rate environment. Because the pool has a longer weighted average maturity, interest rate cuts by the Fed impact the pool's yield at a slower rate than the direct market. For example, when the Fed cuts rates by 50 basis points all security offerings in the market automatically reprice 50 basis points lower. Whereas a pool, with an average maturity of 40 days will not feel the full impact of a 50 bp rate cut until around 40 days after the Fed has acted. This slide shows the performance of LGIP's during rising and declining rate scenarios.

The gold line reflects the Imoneynet prime retail index as a proxy for an LGIP's yield. We use this benchmark because the investments in prime money market funds align very closely with a prime LGIP's investments. The green line shows the Fed funds rate. The chart goes back to January 2016 and reflects both rising and declining rate environments. The blue line on the chart shows the national average three-month CD rate posted by US banks. As we know banks are very slow to react to increases in fed funds rate, but usually respond quickly to interest rate cuts by the Fed. It is important to remember that although an investment in an LGIP is not guaranteed it is structured as a diversified portfolio that offers daily liquidity at par in addition to having provided a current market yield.

Heather: The Fed recently cut the FedFunds target rate by 50 bp on Sept 17. The Fed's dual mandate is to achieve price stability by targeting the inflation rate around 2% while maintaining full employment. What do the inflation and employment situation in the US look like today and what do these numbers signal for the Fed's outlook near term?

Paige: The Fed's inflation goal is to see progress toward that 2% inflation rate over the medium term. If you take a look at the chart on the left hand side, it shows the Fed's favorite indicator for inflation and price stability which is core PCE or personal consumption expenditure. The green bars represent the core PCE on a monthly basis and the blue line indicates the annual rate of inflation. If you look back to the beginning of 2024 you can see a pretty big acceleration in that monthly core PCE number for January, February and March.

This reacceleration of monthly inflation readings is what caused the Fed to stay on hold at the beginning of the year and not cut rates as quickly as the markets were predicting. You might recall that at the end of 2023 the markets were looking for seven 25 basis point interest rate cuts by year end 2024. As we moved into the summer months we started to see the core PCE numbers declining, and the year over year inflation data moving lower. This gave the Fed comfort that core inflation was moving down towards their 2% target. From an employment standpoint, which is on the right hand side of the slide, we can see that non-farm payrolls on a monthly basis, represented by the green bars, were very, very strong throughout 2023 and even into the beginning of 2024.

The unemployment rate, the blue line, remained pretty low from an historical standpoint. As we moved into the second quarter of 2024 non-farm payrolls started to decline and the unemployment rate shifted up to 4.3% in July and 4.1% in August. These recent changes in the employment data are concerning to the Fed as they try to achieve maximum employment in the United States. The Fed feels like the balance of risk to the economy has shifted away from higher inflation and toward the risk of further weakening in the labor market. We are expecting that the Fed will continue to cut rates throughout 2024 at their next two meetings on November 7th and December 18th. Obviously, as the Fed has stated the size and amount of rate cuts will continue to be data dependent. The markets will be heavily focused on how the employment situation unfolds over the next couple of months.

Heather: Finally, looking further ahead, what are FHI's expectations for interest rates in 2025 and 2026?

Paige: Our expectations for 2025 and 2026 are for additional rate cuts from the Fed. We are anticipating that we will see 25 basis point cuts, possibly at every other meeting in 2025. The goal for the Fed is to achieve a soft landing and not cause the US economy to move into recession territory. Regardless of the pace and number of interest rate cuts from the Fed we view the nominal fed funds rate somewhere around 3% at the end of the easing cycle. This means that LGIP yields should be meaningfully positive into the near future.

Heather: Thank you, Paige for these valuable insights and breaking down these complex topics. That brings us to the close of this episode of the Treasury Markets Minute We hope you found today's discussion helpful as you navigating these evolving market conditions. As always, we'd love to hear from you. If there are any specific topics or questions you would like us to address in future episodes, please don't hesitate to reach out to your pool's representatives. Thank you for joining us and we look forward to connecting with you next time.