Bull vs. Bear is a weekly feature where the VettaFi writers’ room takes opposite sides to debate controversial stocks, strategies, or market ideas — with plenty of discussion of ETF ideas to play either angle. For this edition, Nick Wodeshick and Nick Peters-Golden debate whether rate cuts will still arrive this year.
Nick Peters-Golden: Hi Nick! I’m excited to discuss this with you. This is probably the biggest question facing U.S. investors this year, and I think they’re likely to be disappointed.
Nick Wodeshick: Hey Nick! The feeling is mutual. I totally understand why some investors are uneasy about rate cuts after the latest CPI numbers. However, I still think some rate adjustments could remain on the table for later this year.
Peters-Golden: Look, I would love for rate cuts to happen. Not only for the many investors who’ve priced in such moves, but, who doesn’t love to refinance? However, I fear that’s not going to be the case. Let’s get into it!
Staying the Course on Rate Cuts
Wodeshick: Sure, inflation has stuck around longer than the market hoped, but we’re still seeing signs of improvement. Core PCE recently beat analyst expectations, marking a sharp drop over last year’s numbers. Federal Reserve Chair Jerome Powell noted last month that the findings were “more along the lines of what we want to see.” The PCE index’s ability to deliver good results remains a key factor to keep in mind, given the Fed’s preference for the PCE as an inflation gauge.
That said, the CPI report will certainly provoke more hesitation from the Federal Reserve before beginning rate cuts. A portion of the higher-than-expected CPI data can be attributed to volatile price changes within the food category, especially with butter and egg prices. However, the data overall still shows a significant year-over-year decline, dropping 1.5% from last year’s numbers. The Fed’s inflation fight is certainly not over, but strong signals still show that inflation is easing.
Some say that rate cuts are unnecessary this year due to the perceived strength of the U.S. economy. However, the economic landscape is not as rosy as some might assume. Despite some strong signals within the U.S. labor market, the unemployment rate remains up 0.3% over last year’s findings. The unsatisfactory unemployment data could provide a significant indicator that the U.S. economy isn’t currently as robust as investors perceive it to be.
Outside of extraneous circumstances during the early stages of COVID-19 lockdowns, the last rate cuts from the Federal Reserve happened in 2019, which Powell referred to as “mid-cycle” adjustments. These three cuts occurred in the second half of the year, with each cut being 25 basis points. The cuts were made with the PCE remaining under the central bank’s 2% target. If monthly PCE releases continue to deliver satisfactory results for the Fed, the case could be solidified for a few modest quarter-point cuts occurring later this year.
Higher for Longer
Peters-Golden: Listen, I get it. Investors saw rates rise at a near-record pace over the last few years. We’ve come such a long way from daily predictions of rate-hike-induced recession just 12 months ago. It’s hard not to expect the pendulum to swing back.
However, just because rates rose quickly doesn’t mean that a soft landing, rather than a recessionary crash, will see them unfurl just as quickly. Consider that, historically, rates have dropped quickly amid downturns. Right now, the economy is still chugging along. It’s doing so well, actually, that inflation remains a big challenge.
This past week, it was the consumer price index (CPI) that took the role of party pooper for a rate-cut-inspired boom. Headline price growth grew to 3.5% year over year (YoY) for March compared to 3.2% in February. That represents the first time core inflation has accelerated in a calendar year.
While price growth in some areas has cooled, services remain tough. Per coverage in Barrons, that owes to services inflation being somewhat less exposed to interest rates. Services alone don’t speak to rising prices in other more complicated areas, like insurance. Ongoing supply chain shortages, new, more complicated car parts, and other changes are spiking insurance costs.
We could go back and forth on the inflation data, but let’s take a step back and look at the predictions out there. The CME Fed Watch Tool forecasts the “first” cut to hit as late as September. One or two more data drops like this most recent CPI report could easily push that to next year, given how much the holiday season heats up the economy.
None of this, mind you, includes the implications of the 2024 election. The Fed wants to remain independent, but a rate cut just in time to influence the presidential election, whether independently decided or not, would invite significant backlash.
Aiming for September
Wodeshick: Many market analysts still remain confident that interest rate cuts could come to fruition this year. Kiplinger’s David Payne noted, “There is still a decent chance of a rate cut this summer.” Kiplinger forecasts shelter inflation lowering down the line due to smaller rent hikes. Shelter inflation remains a significant component of the CPI. However, Payne does note that the next few inflation reports remain crucial for providing space for a rate cut.
CNBC noted that the CME Group’s FedWatch tool has moved bets off the previously favored June meeting for a potential rate cut. The trader monitoring tool is now leaning toward a September rate cut, anticipating two cuts in total for 2024.
Along with remaining rate cut optimism from the market, notes from the Federal Reserve’s meeting last month can help illuminate the central bank’s plan going forward. The minutes show that most of the Federal Reserve’s senior officials believed it would be “appropriate to move policy to a less restrictive stance at some point this year if the economy evolved broadly as they expected.” While this meeting occurred before the latest CPI data could be considered, the minutes note that the Fed believed the path to disinflation “was generally expected to be somewhat uneven.”
The Fed’s latest dot plot can provide additional guidance toward the central bank’s expectations. Of the 19 senior officials within the Federal Reserve, 17 of them are anticipating at least one interest rate cut to occur within 2024. This dot plot comes as the Fed minutes noted expectations for 0.75 percentage points worth of cuts in the year.
Overall, the Federal Reserve minutes indicate that the central bank is awaiting more confident indicators that inflation is receding. With the latest CPI data showing some position of strength for the U.S. economy, the Fed can afford to wait until the second half of the year to see stronger results from the PCE and CPI reports. Patience is a virtue, especially given how some of the March CPI growth was driven by more volatile price sectors. Toward the end of the summer, the Fed should better understand the current inflation path, providing a potential opportunity for tweaking interest rates.
A New Normal?
Peters-Golden: So much of the rate cuts conversation, unsurprisingly, is influenced by the rapid pace of rate hikes in 2022 and 2023. As I hinted above, I think many investors expect rates to decrease at a commensurate pace to the speed at which they increased. They’re looking for rates to come back down closer to where they were before they rose so much. That said, that thinking misses a very obvious idea — that rates were abnormally low prior to the big spike we’re talking about.
It doesn’t take a Fed-watching obsessive to recognize that the post-global financial crisis (GFC) economic environment saw abnormally low rates. According to historical fed funds charts, between the end of the GFC in 2009 and 2016, rates sat at less than 25 basis points (bps).
Those low rates were unprecedented in American history. So, rates now are perhaps more similar to standard monetary policy than they are to rates following the GFC. Looking at the broad scope of history, there’s no inherent reason for rates to come back down very quickly. A live rate market offers its own benefits and can provide meaningful information about macroeconomic conditions.
With that in mind, investors may want to reset expectations about where interest rates should be. A higher-for-longer regime, then, maybe “much” longer than anticipated. Higher now, for what it’s worth, used to be “normal” then. The Fed knows this and can see that long view.
Together, that undercuts some of the urgency investors may feel. Investors may feel the current rates are very abnormal, but to the Fed, it likely falls right in line with the historical average.
High Income Options for Rate Cuts
Wodeshick: For investors anticipating rate cuts in 2024, ALPS offers a number of ETFs that are positioned to offer benefits. For example, the ALPS Active REIT ETF (REIT) can provide investors with robust exposure to the real estate market. Prioritizing return and capital appreciation, the fund uses an actively managed strategy to invest most assets into REITs. REITs can potentially provide consistent, risk-adjusted returns.
Broadly speaking, the real estate sector stands to gain from potential interest rate drops. Lower rates can lead to more affordable mortgages, potentially heralding a period of recovery for the real estate industry. REITs can deliver good returns during periods of real estate recovery, making the fund a strong option for investors and traders seeking potential real estate gains. The fund is actively managed, providing additional flexibility and versatility to adapt to rate cuts as they occur.
Investors seeking current income and broad company exposure could utilize the ALPS O’Shares U.S. Quality Dividend ETF (OUSA). The fund seeks dividend growth from a selection of large-cap and mid-cap stocks. In selecting assets, OUSA measures a multifactor screening process to evaluate quality, volatility, dividend quality, and dividend yield. As a result, OUSA holds assets in established, reliable companies such as Microsoft, JPMorgan, and Visa. The fund’s wide selection of quality holdings can help provide investor assurance ahead of rate shifts.
Dividend investing remains a solid option for gaining returns during interest rate cuts. A dividend strategy can provide investors with consistent yields following a rate cut while offering the potential for market outperformance. Interest rate cuts can lead to increased borrowing, more investor interest, and higher stock prices, all of which can add to stronger company payouts. Meanwhile, many short-term instruments risk providing lower yields during low interest rates. These conditions can make dividend strategies an ideal option for providing strong income for investors.
Options for No Cuts
Peters-Golden: Listen, if rates aren’t dropping this year, that would mean quite a lot for investors. Investors should be prepared for either eventuality, but I believe that whatever happens will be far less than investors think. My take is there will be zero cuts, but either way, I’m looking at strategies that will do better amid a higher for longer regime.
What kind of ETFs, then, would appeal? To start, it may be worth taking a look at an asset class some folks don’t regularly consider: master limited partnerships (MLPS). Those are publicly traded, limited partnerships focusing on natural resources and real estate. They offer strong tax advantages thanks to the partnership model, avoiding corporate income taxes at federal and state levels.
The Alerian MLP ETF (AMLP) provides a solid route into the space. Charging 85 bps, it offers quarterly dincome distributionsto boost portfolios and help investors. It tracks the Alerian MLP Infrastructure Index, focusing entirely on domestic U.S. MLPs. It has returned 22.8% over the last three years—solid performance amid spiking rates.
Active ETFs would appeal, too, if rates don’t drop. The ALPS Active Equity Opportunity ETF (RFFC) has returned 24.2% over one year. Its strategy provides its managers with a broad remit to actively invest. The ETF invests in small-, mid-, and large-cap equities, including REITs. It looks for dividend payers and other appealing firms.
That equity flexibility not only empowers the strategy to look for opportunities across multiple segments but can also help it find firms with strong fundamentals that can do well despite a higher-for-longer regime. Charging just 48 bps presents another strong option.
Of course, perhaps no asset class appeals in higher-for-longer as much as fixed income. Fixed income yields are not as high as a few months ago, but they’re still much more alive than before the rapid rate hikes.
A strategy like the WisdomTree Floating Rate Treasury Fund (USFR), which charges 15 bps, offers one strong option. Its reliance on floating rate notes helps it provide consistent, rolling exposure to rates as set at the most recent 90-day T-bill auction. USFR currently offers a 5.35% SEC 30-day yield, per its website.
VettaFi LLC (“VettaFi”) is the index provider for OUSA and AMLP, for which it receives an index licensing fee. However, OUSA and AMLP are not issued, sponsored, endorsed, or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of OUSA.
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