Fixed Income Clarity in an Uncertain Fed Cycle with Kevin Flanagan

With the shutdown delaying key data issues, how are you navigating this flying blind environment and what indicators are you watching most closely?

[00:00:33] Kevin Flanagan: I know, being a bond guy for over 30 years, it leaves you wanting, you want something, you want some kind of economic data to come out. Obviously we're not getting the full lineup of economic reports, but there have been some drips and drabs.

There are some private surveys out there like ISM and S&P Global, which give us manufacturing servicing data. There's Johnson Red Book. I'm dating myself going back. That measures over 9,000, I think, general merchandise retailers. We have gotten some of the consumer sentiment indexes, like from the University of Michigan, so it's not a complete data void.

But to your point, you are flying blind in this. And it's not just the markets. The Fed as well, which is interesting. Now the Fed can use their regional bank system, I think, for anecdotal evidence like they do for the beige book. But you're certainly not getting the full compliment and we're only a couple weeks away now from the next Fed meeting.

[00:01:34] Doug Heikkinen: Speaking of the Fed, in your recent Fed Watch post, you drew parallels between this easing cycle and past ones. Where do you see the biggest similarities and differences?

[00:01:46] Kevin Flanagan: So this year, last year you got your first rate cut and the resumption of rate cuts at the September FOMC meeting.

One being a quarter, one and a half, obviously, but it was due to some changes in perceptions on the labor markets that we saw over the summer months, which was interesting. So those were certainly I think the similarities. What we're going to try to find out now, is there going to be any difference in the cadence and magnitude of future rate cuts?

The expectations are the Fed will give us another quarter point in a couple of weeks at the October FOMC meeting, and then we'll see about December. I don't think the Fed right now is looking to provide major stimulus. To use Powell's own phrase, he looks at this as more risk management monetary policy.

So if that's the case, maybe we only get a couple more rate cuts in this cycle.

[00:02:41] Doug Heikkinen: How much should investors pay attention to the political noise around Fed independence or leadership changes when positioning fixed income portfolios?

[00:02:50] Kevin Flanagan: I think it has been a bit overblown of late. It's interesting, CNBC reported last week that the shortlist has been narrowed down from 11 to five.

Three of the names, Chris Waller, Michelle Bowman, Kevin Warsh, are either currently at the Fed or have been at the Fed sitting at the FOMC table. Now, Kevin Hassett and Rick Rieder, obviously a little bit different. So I think from the market's vantage point, they don't show any signs of concern with the shortlist.

It's now been out for a few days. If there was any kind of concern, I think you would've seen longer dated yields rise, such as the 10-year. Matter of fact, it's done just the opposite. It's actually come down a little bit. I think overall the way you look at this, markets don't like uncertainty. They prefer to know more with certainty what outcomes are going to be such as this. And if you were to take it one step further, the bond market, if you were to ask if the bond market could speak and you were to ask it, what would you prefer? They would probably say, I'd like to have somebody who's either been at the Fed or is at the Fed currently.

So that's the way we're at it. But even Kevin Hassett, Rick Rieder, I think they understand the gravity of the situation of being the most central, the most powerful central banker in the world. As of right now, I think it's an overblown concern.

[00:04:13] Doug Heikkinen: How do you define the current neutral rate, and what does that imply for how long the Fed can hold or cut from here?

[00:04:21] Kevin Flanagan: That's a great question and it's going to really go in determining where the Fed stops in this rate cut cycle. So if you assume, as we were talking before, that the Fed cuts rates two more times, a quarter point each, that brings the Fed funds target down to three and a half, 3.75. Some would argue three and a half is a neutral rate for Fed funds. So if that's the case, maybe they go October, they go December for a little Christmas gift, and that's the end of it. Depending upon the economic data, of course, hopefully the shutdown will end and we'll be getting fresh economic numbers and the Fed can go on from there.

Now, if you were to see further weakening in the labor market, and it begins to impact the broader economic numbers, which by the way, have been relatively solid outside of the labor market numbers. Then you start thinking the Fed may have to move a little bit more than that. But right now, I think, 3% or below just does not seem to be the more likely scenario.

At this point.

[00:05:21] Doug Heikkinen: You've called treasury floating rate notes a cornerstone bond strategy. What makes them compelling now, even as rates may be cut in the future?

[00:05:33] Kevin Flanagan: That's the interesting part of this. Floating rate notes, most people would associate that with rising rates. But the difference with treasury floating rate notes, other than the fact they're a hundred percent Us treasuries, is that they're reset every week with the three month T-bill auction, plus a spread. And that spread is very interesting. Remember, they're not a one or a three month treasury bill. They're actually a two year maturity, but it's reset weekly, so you have a spread there as well. And it also stays with the life of the security, which we will getting a brand new auction in a couple of weeks.

So that spread has actually been widening. And, that's a function of demand, right? So when rates are falling, if you see spreads or demand faltering a little bit, that spread does tend to widen. So it's around 20 basis points or so as we're talking here on this podcast. You're actually picking up money market or T-bill rates plus say, roughly 20 basis points.

When you look at the treasury yield curve, the 20 and 30 year bonds are the only securities that have higher yields than that. The 10 year treasury is right around the same spot. So for very limited duration you get the same type of yield. So there's no urgency really to consider, I think, making any wholesale moves out. You could barbell or something like that with treasury floating rate notes, but that's why I think they remain the cornerstone. Because they can help with your, we use the term risk management before, interest rate risk management. They can go a long way in helping you go ebb and flow as to what you want to do, depending upon the rate outlook.

[00:07:21] Doug Heikkinen: How does WisdomsTree's yield enhanced core strategy AGGY differ from traditional aggregate, and when does that difference matter most?

[00:07:32] Kevin Flanagan: AGGY just celebrated its 10 year anniversary this year, ringing the bell at the New York Stock Exchange. First time I ever got to do that. That was fun. And what we did was we realized that when you look at a market cap based approach in fixed income, whether it's the index or the fund, the more debt you have outstanding, the more weight you get.

And, to us that's counterintuitive being bond people. It's almost like you're rewarding an entity for issuing debt. So we thought maybe there's a better way of doing this. So we use a guardrail of say, roughly plus or minus 20%, and we take the ag, which by the way is well over 40% now in treasuries.

And you may ask, why is that? we're running nearly $2 trillion deficits. So treasury supply has exploded over the last couple of years, hence that 40% more debt outstanding. So we're going to reapply that or reweight that to investment grade corporates, maybe to federal agency securities.

So for a similar risk profile as the ag, similar type of duration for the most part, there's guardrails with that as well. You can pick up additional or enhanced yield over the ag. And to us that makes a lot of sense in this environment. So you're not adding leverage, you're not adding em or high yield.

You're just re-weighting the sectors or sub components of the ag to achieve that enhanced yield and get somewhat, if not hopefully, better performance as well as the ag. And I talked about a barbell before. It's a very nice tool to pair with treasury floating rate notes.

[00:09:09] Doug Heikkinen: So walk us through your active-passive barbell approach and what problem does it solve for advisors who are building fixed income allocations today for their clients?

[00:09:20] Kevin Flanagan: One of the first things you usually look at when you're investing in fixed income, is what is my duration profile? Another would be what is my credit profile? So when you're looking at a barbell strategy, you're actually getting a very user friendly approach, right? Typically speaking, when you talk to financial advisors and even end investors as well, I think the less line items you have, you tend to appreciate that more when you get your monthly statement. So the barbell can help you mitigate that duration or interest rate risk, say pairing a USFR, which is one week duration, with say AGGY, which is more like core. And if you do a 50/50 kind of split, you're getting roughly a similar yield as the ag, but with almost three years less duration.

So you're, I think, checking off a lot of boxes in that profile and you're not necessarily adding any kind of credit risk per se, out of the investment grade realm. But if you wanted to do, people talk about Core Plus, you could say, barbell plus. You could do the same thing where you start off with two tickers such as USFR and AGGY.

Maybe you wanna add a little high yield, maybe you want to add a little emerging market, maybe a little private credit, something along those lines. Or maybe mortgage backed securities. So I think it's, we started the conversation as USFR, as being the cornerstone, but really the bedrock is this barbell strategy of where you have the flexibility to toggle back and forth, depending upon what your risk and rate profile are, and are they changing over the course of a year?

[00:11:00] Doug Heikkinen: How are you currently balancing duration and curve exposure amid certainty over whether long yields will follow the short rates lower?

[00:11:09] Kevin Flanagan: That's I think a very interesting question that a lot of people get confused over, is just because the Fed is cutting rates doesn't mean all rates are going to respond in the same fashion or manner.

A perfect example was when just recently, when the Fed cut rates by 25 basis points, the 10 year treasury yield on the day of the Fed rate cut to where we were a week or so ago, actually rose 20 basis points. If you go back to last year when the fed cut rates in September by 50 basis points, a half a point, added another half a point onto that, the 10 year treasury went from 3.6% at that September or around that September meeting to about 4.8% early this year. So a lot of things come into play when you're looking at interest rates slash duration the further you go out on the yield curve. You get further and further removed from the actual fed funds rate. What are your economic expectations, your inflation expectations, supply, deficits, all of that play a role into the mix and just remove you and layer you out from the Fed funds rate the further you go out. And what we have seen is that if you're nimble, perhaps you can make a total return play by moving in duration. But it's not something that we would recommend or advise because what we have seen is, increasing duration has been a very fleeting strategy over the last couple years.

[00:12:44] Doug Heikkinen: Kevin, last one for you. Okay. Looking ahead of 2026, what's your best case for the Fed and yields and how should advisors prepare portfolio for the next regime shift?

[00:12:54] Kevin Flanagan: If the Fed does get to neutral, as we were talking about before, and say we get two more quarter point cuts, I think the Fed would still be skewed more towards rate cuts, obviously, than rate hikes, and a lot will depend upon the labor market data. Now, the Fed likes to talk about their dual mandate, employment and inflation. But really they're not equal right now.

Right now employment is carrying the day. That could change. You don't know. But as of now, that's the case. So I would say right now for the Fed for 2026, I would say policy is somewhat neutral, maybe skewed towards another rate cut as we move forward.

In terms of yields, our base case does not look for a recession here in the US we look for inflation to grind higher. That's an important distinction. We don't look for any return to where we were a couple of years ago. And I think in that environment, the 10 year treasury yield trading with a four handle on it, four, four and a quarter, four and a half, at least for the first half of next year is a more likely scenario.

[00:13:58] Doug Heikkinen: Kevin, always interesting and incredibly informative. Thank you so much for being with us.

[00:14:05] Kevin Flanagan: Thanks. I appreciate it.

[00:14:06] Doug Heikkinen: For more information about WisdomTree, please visit them WisdomTree.com. We are on all social media platforms @Advisorpedia. For our producer Tory Miller and everyone at Advisorpedia, thank you so much for listening.

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