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Cestrian Capital Research’s Yimin Xu talks past easing cycles, strong economic data and Fed rate cuts (0:40). Sticky Inflation and Bond Market Equilibrium (2:30). Attractive 10-year returns (5:00). This is an excerpt from a conversation on the Seeking Alpha Investing Experts Podcast.
transcript
Rainer Scherbier: Xu Yimin, welcome to Seeking Alpha. You write for Seeking Alpha News, you work with Cestrian Capital Research on YouTube, and by the way, if this sounds familiar, we have Alex King who has run their investment group service many times before.
How do you view the market? There has been a lot of discussion, especially recently, about the Federal Reserve. How do you think about something you want that is both broad and specific?
Yimin Xu: Many investors are worried that the strong data means the Fed will cut interest rates soon, so that would be negative for stocks. But actually, historically, if you look at past easing cycles, there was a period in 1995 when GDP growth was very stable. That’s down slightly from 1994, but still very strong.
The Fed is slightly concerned about inflation, which has come down from the highs of the early 1990s, but realistically, they’re willing to wait for soft inflation and wait — sorry for the soft landing and the inflation numbers are down and lower than you expected. The market is much later. What happens is stocks rise because a good economy translates into stronger earnings, and that’s not always a bad thing.
When we see a big rate cut from the Fed, it sometimes means it’s driven by recession fears, which means slower economic growth and slower profits. That’s not always a good thing for the stock market.
So I think at this time, the good news is actually the good news at this moment. Only when it is too late for the Fed to actually start cutting rates and we see bad data coming without the Fed taking drastic measures should we start to worry. That’s how I feel about macro right now. So, actually I am still very optimistic.
RS: How do you tie that to what’s happening in the bond market? How do you think investors should think about the bond market and position themselves in this part of the market?
YX: So at the beginning of the year, the bond market priced in seven price cuts, sorry, seven rate cuts in 2024. This is so radical, but I actually understand why this is the case. There is actually a reason for this. The reason is, if you look at real interest rates, even if the Fed takes no action, if inflation falls, real interest rates will rise.
If inflation is as predicted by the Federal Reserve in its December Federal Open Market Committee (FOMC) meeting, it will rise to 2.5% by the end of the year, or 2.4%. If you give a neutral rate (real neutral rate) or take 1 to 1.5 percentage points, then our nominal rate target is 4% because the market is neutral.
Today’s effective federal funds rate is 5.33%. So, to get to the neutral rate, we really only have 6 cuts, right? So it makes sense. The market is optimistic that inflation will fall steadily. We hit our personal consumption spending target, and the Fed should loosen accordingly to reach a neutral rate. But it is now clear that inflation is a bit sticky, and inflation always ends up taking longer than the market expected. Therefore, we expect four rate cuts this year.
I actually think 3 or 4 rate cuts are about right, it’s about equilibrium. If we go below 3, then it’s probably too little. If we had more than 4, it would probably be too many. That’s simply because inflation may be slightly higher than investors expected late last year.
So, I think the bond market is in a good equilibrium right now. I’m actually on the edge that I would be a buyer here just because I don’t think inflation is going to come back as strong as the Fed thinks. So, over the long term, the yield curve should normalize and we should see steady rate cuts over the next two years.
So from a marginal perspective, I think buying bonds here is not bad. Not too bad. I don’t think it’s possible for us to only have 1 or 2 cuts this year, and I think 3 or 4 cuts this year is fair at this point, yes.
RS: As far as the Treasury market is concerned, if you think there is something worth investing in there, do you have any thoughts?
YX: I think for a long time everyone was very concerned that QT would conflict with the timing of Treasury issuance to boost the Treasury general account, which is the currency the U.S. Treasury holds, and actually suppress demand for Treasuries, and in fact, last year most of the time.
If you look at every time the Treasury issues a bond, bond yields always go up because the Fed is no longer really a margin buyer compared to the previous two years, but actually I think now because investors Knowing that the path ahead is an easing cycle, the current 10-year rate of 4.25% remains relatively attractive given where yields are heading in the future.
So I do think that if you’re a long-term investor, long-term yields (I think the yield curve is comparable) offer pretty good value right now.
It’s also interesting to note that many banks get burned during rising interest rate cycles. I mean, if you look at last year’s regional banking crisis, regional banks locked in 10-year yields at 2%, the Fed raised interest rates sharply, and bond portfolios basically fell, right, in value. Silicon Valley Bank (OTC: SIVBQ ) is bankrupt, but even Bank of America (BAC) has suffered huge losses in portfolio value.
Now, on the way down, that could be a good thing for banks that had a lot of bonds when they bought them two years ago and held them to maturity. Now, as we cut interest rates and bond prices rise, valuations are rising.
So I think, in a way, I’m a buyer here. I think on the curve, the curve is not, it’s obviously inverted now, but it’s also kind of flat. I think the 10-year, I prefer the 10-year to the short-term — just because we, the 10-year is still priced very high with relatively high stable inflation that’s not going to continue and is pretty high. The most important thing about neutral is the rating. So, I think that probably provides better value than the short-term portion of the yield curve.
