Fixed Income for a New Fed Era with Kevin Flanagan

Can you tell us what you mean by that and describe the current Fed policy environment?

[00:00:29] Kevin Flanagan: Yeah. You know, and I think for good news for people like me who write and blog and podcast, the last name Warsh has provided us with some fun taglines. So that's the latest one that we have. But I mean, to your question, I think what we're finding out is that new Chair Warsh was not going to ever be a rubber stamp for rate cuts, and he's putting his stamp on monetary policy in different ways.

Obviously, the five task forces that he's formed, as well as what could come about, about how the Fed conducts monetary policy. In other words, what goes into the decision-making process, and as important, how you communicate that to the public. And I think this is something the markets are going to have to get used to because most people, who have come up in the markets, say, in the last 15, 20 years, they're used to a Fed providing forward guidance, and we're finding out that's going the way of the cuckoo, for those that may remember that expression.

[00:01:34] Doug Heikkinen: Continuing on in that vein, what's the most significant changes investors should expect in how the Fed conducts monetary policy and communicates its decisions under Chair Warsh?

[00:01:46] Kevin Flanagan: Yeah, so I mean, what's interesting is, it's not as if Chair Warsh was a new person at the Fed.

We do have some examples of what he was like as Fed governor. So that's what I find interesting. It wasn't as if this was somebody who just came in and we found out about. Some of this was kind of advertised, if you... or telegraphed, if you looked. And, one of them was obviously in terms of the balance sheet.

I mean, that's a whole nother probably podcast to talk about, but, and it is one of the task forces. But he was never a huge fan of the balance sheet, but recognized the importance of how it can be used as well. So but that's something that's a little bit further down the road. So what was easy?

What was something that Warsh could accomplish sooner rather than later, call it that low-hanging fruit, and that was forward guidance in the messaging of their policy statement. And I think what you found out there was Warsh was able to bring the Federal Open Market Committee together, I think voting members and non-voting members, and say, "Hey, look, let's talk about this.

Let's see if we can do a more streamlined, let's call it a Greenspan-esque version of the policy statement, where it's just the facts and it's not teetering onto, 'Okay, this is what we're tilted towards doing,' that kind of a thing." And that's what we got at the June FOMC meeting. Now, the other part of that obviously is in terms of the forward guidance with the dot plot.

The dot plot has become an obsession almost with the market when it would come out four times a year, but the accuracy, or shall we say the predictability of the dot plot was horrible. Its track record was not good at all. And I think it was very instructive when you found out that 18 out of the 19 Fed members did vote for a dot plot.

There was one who didn't, and he mentioned, "It was me. That's right, Kevin Warsh. I decided not to do the dot plot." So I think when we're talking about forward guidance going forward, you have this more streamlined approach. But, you know, Doug, that also brings about the question of volatility

[00:03:57] Doug Heikkinen: Okay. So how might money markets and bond markets need to adjust as the Fed moves towards this new monetary policy framework?

[00:04:07] Kevin Flanagan: Well, that's it. I, think a lot of it is the volatility that we sort of knew. It was kind of baked in the cake, what the Fed would do at an upcoming meeting, based upon some of this prior forward guidance under Powell, under Yellen, that type of a thing.

Now it's a little bit more iffy, right? So now as the data come in, because the Fed still remains, if there is a constant, it's the Fed is going to remain very data-dependent. So, you know, whether it's the labor markets, it's the inflation numbers, it's maybe some of this new data that he talks about, real time data that we see, as each number comes in, the market then is left to interpret on its own what that could mean for Fed policy.

And in my opinion, you know, I've been there. I was there under Greenspan, and now I'm here under Warsh, and I've seen when there was basically no communication from the Fed versus what we had just recently as Powell. Well, he didn't quite exit the building, but shall we say, exited the chair seat, at this stage of the game.

And I think you can make an argument for both ways creates a volatile backdrop, and I think that's what the money and bond markets will be contending with.

[00:05:20] Doug Heikkinen: So for investors who became accustomed to unusually low interest rates over the past decade, what does a return to a more normal rate environment look like?

And would you call it that?

[00:05:32] Kevin Flanagan: Yeah. You know, it's great. You know, before we, we came on real quickly, we threw out a little movie reference and got a chuckle. I'll give you another one. So I think for a lot of investors, who came into the market, as I said before, post, say, financial crisis, they're used to zero interest rates, negative interest rates, 1%, 2%.

I would call that Young Frankenstein, Doug, Abby Normal. That is not normal. Normal interest rates are more what we're seeing now, four handles on Treasury coupons as you move forward. So that's what I think. If you go back to 1988 to roughly, say, you know, 2007, '08, '10, these were kind of like the average rates you would see in the bond market.

Maybe a little bit higher, but certainly a lot more than what we saw from 2010 to 2021. So that's what I think investors are going to need to get used to, and you're beginning to see that, I think. And I think one perfect example is, even though the Fed just cut rates over the last couple of years by 150 basis points, you're still seeing money market rates in that three and a half, three and three quarters.

And I think investors look at that and they go, "Geez, that's not so bad," rather than moving out in duration. So that's what I think investors are, I think, positioning themselves for, that, people used to say higher for longer. It's more like, yeah, higher for longer. How about we're back to normal?

[00:07:04] Doug Heikkinen: Yeah. You may be dating us with that movie reference, but for those who haven't seen Young Frankenstein, do yourself a favor. Do you believe in interest rates could remain higher for longer than many investors currently expect? And what could that mean for the bond market volatility?

[00:07:21] Kevin Flanagan: Yeah. You know, I mean, that's the environment we're in.

So for those who are now getting accustomed to what we call this normal rate setting, it is higher for longer. And we're not going back to 1%. If we are, that's because something really bad happened. So even if you're in an environment where you would move, say, into a recession, inflation comes down, that's not our base case, but, you know, just saying it for argument's sake, then maybe you could see a 10-year Treasury dip below 4%, as we've seen before.

But that's probably the extent of it. And even the Fed cutting rates, they only brought you down to 3.5%. And so those days of zero, 50 basis points, 1%, 2% are a thing of the past. And I think that is what bond market participants are now finding themselves in this type of position, that wait, well, rates have to come down, they have to come down.

And I think they're finding out, no, they really don't.

[00:08:19] Doug Heikkinen: How should investors think about duration risk when positioning fixed income portfolios for this changing environment?

[00:08:28] Kevin Flanagan: It's, alive and well. So, you know, we've always been a proponent of being late to the duration party. I would much rather be late than early, and I think we've been finding that out.

Chasing duration has been a fleeting strategy. If you go back over the last, say, call it two or three years, it seems that almost every time you had a rally in, say, the 10-year Treasury market and the yield would come down, it didn't stick. It wasn't evergreen, and it would move right back up again.

If you actually look at a chart, we've been operating in a 4 to 4.5% range for the 10-year Treasury since the Fed started raising rates post-COVID. And when we tend to go out, whether it's an overshoot or an undershoot, it doesn't last very long. And I think that is what, once again, investors should prepare themselves for.

Now, we're in an environment right now as we're talking where we're overshooting that 4.5%, and there's obvious reasons for that as well. But, for all intents and purposes, we're still right around the upper part of that band that I just talked about, that 4.5%. So some would ask, okay, well, how do you go towards 5%?

Could you have a more permanent, or let's call it sticky, kind of yield in the 10-year above that four and a half? Well, inflation needs to stay above Fed target, which I think it will continue to do. I don't necessarily think you're going to see a big surge in inflation. Labor market, once again, not cooling, showing as it did gains in payroll, 75,000, 100,000, kind of right where the three-month moving average is.

But one thing I'm watching out for as we look ahead is supply. Supply is not a primary factor, but it can be a secondary factor. And we're going to find out in the next few months, does Treasury need to raise coupon auction sizes? We're funding a $2 trillion deficit. Not being political, that's just the facts, right?

And, I think what we're finding out is T-bills may not be able to carry the burden all the time. So if you were to ask me, is there more of a chance you overshoot for a longer period of time? I would say yes

[00:10:47] Doug Heikkinen: Right. Where can investors still find attractive income opportunities while limiting their exposure to rising rates and increased volatility?

[00:10:57] Kevin Flanagan: Well, I mean, you know, in WisdomTree, we have what I like to call a zero duration suite, where there's actually three different solutions. One of them is our Treasury floating rate fund. The ticker there is USFR, and it's based on 100% Treasuries. it floats with the weekly three-month T bill auction plus a spread.

So that's kinda your anchor. It's your cornerstone, I think, of a strategy. And then we have a interest rate hedged US aggregate bond fund, where we're basically taking the ag and we're stripping out duration by shorting Treasury futures. So essentially, you're left with the ag, but with no duration. And once again, that's an investment-grade kind of solution where you're going to pick up some additional yield the-- rather than just being in 100% Treasuries.

Then if you want a core plus kind of a component, we have an interest rate hedged high yield fund, HYZD, where we have a quality screening on the HY, the high yield part, once again using Treasury futures to strip out that duration. So you can use them individually, you could use them all together. I've been doing this a long time, and I always hear from financial advisors, especially for fixed income, "Can you limit the tickers, please, for my portfolio?"

That's only three right there. So you have a Treasury-based, an ag-based, and a core plus kind of component, all with essentially zero duration, to me providing income without rate risk, without the volatility we've been discussing

[00:12:35] Doug Heikkinen: How can strategies such as a floating rate Treasury exposure, interest rate hedge bonds, and interest rate hedge high yield help address these portfolio challenges?

[00:12:47] Kevin Flanagan: Well, that's the point, right, that we were just discussing, that you have these three different options that you can use. You know, for some that maybe want to be more risk-averse, you use, say, one that's 100% Treasuries. Maybe you want to pair that with something that's ag-like. Maybe you want that plus component, something a little bit more that you're offered in the high yield sphere.

That's where I think it's very important that you're looking at these three different solutions that you could actually combine together, where you could limit that volatility, limit that duration risk, but once again, enhance your portfolio from the income perspective by shifting the risk's characteristics from something that includes Treasuries, as well as high yield with a little investment grade in between.

[00:13:40] Doug Heikkinen: All right, last one for you. From a broader portfolio perspective, how can a barbell approach combining short-term floating rate Treasuries with a diversified core bond allocation provide investors with flexibility across different rate environments?

[00:13:56] Kevin Flanagan: Yeah, so I mean, that's a great question because for some investors who are like, "Okay, you know, I'm looking at my screens.

I'm seeing a 10-year Treasury yield at over 4.6%." And some would argue, "You know, I don't want to be overly concentrated in a ultra-short zero duration strategy. Yes, I want that in my portfolio just in case, but you know something? I want to move a little bit further out in duration. I want to see if I can capture a little bit more yield by moving further out on the yield curve."

Once again, not changing, trying to manage duration. And I think when you have that combination of, say, USFR Treasury floating rate note with something, what we call our yield enhanced ag, AGGY, you get that combination, where you're getting the income or yield that's similar, say, to an ag, but you're reducing duration.

Didn't eliminate it, but you reduce the duration profile. So to me, there's two ways to do it. You can do it on the zero duration side or the barbell, or you can do some combination between the two.

[00:15:08] Doug Heikkinen: Kevin, that's great. It's always so nice to spend some time with you. Thank you for joining us.

[00:15:14] Kevin Flanagan: Thanks a lot, Doug.

Appreciate it.

[00:15:15] Doug Heikkinen: All right. To learn more about WisdomTree, please visit wisdomtree.com. For our producer Tory Miller and everyone here, I'm Doug Heikkinen. Thank you so much for listening.

[00:15:29] Disclosure: Before investing, carefully consider a fund's investment objectives, risk, charges, and expenses contained in the prospectus available at wisdomtree.com/investments. Read it carefully. There are risks involved with investing, including the possible loss of principle.