Fed: ‘Strong economic backdrop’ enabling fast tightening cycle, economist says

Wells Fargo Senior Economist Sarah House and R.J. Gallo, Federated Hermes Senior Portfolio Manager, join Yahoo Finance Live to discuss the Fed's recession concerns, balance sheet shrinking, and economic recovery narratives seen in the bond market.

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SEANA SMITH: We want to bring back in our panel from the top of the hour. We have RJ Gallo, Federated Hermes senior portfolio manager, and Sarah House, Wells Fargo senior economist, as we wait for Fed Chair Jay Powell to begin his remarks. Sarah, first to you, which is, what questions would you have for Powell this afternoon?

SARAH HOUSE: So I want to know more about their tolerance for growth, slowdown, or a potential recession, and inflation. So do they need to get back to 2%, no matter what, whatever it takes? Or if we see the economy slipping into a recession, at that point, are they maybe willing to ease up on the pace of tightening and perhaps let inflation run somewhat over 2%? And if so, roughly what rate, if that means mitigating the outright contraction in the economy? So just trying to get a better sense of that tradeoff between inflation and growth, given just how tricky of a situation the Fed finds itself in.

DAVE BRIGGS: Just in case our Brian Cheung is taking notes, RJ, what would you like to ask the Fed Chair?

RJ GALLO: I'd be focused on the balance sheet plan, myself. In particular, a number of years ago, I worked at the Federal Reserve Bank of New York. The system open market account was less than a trillion dollars, and it was basically all treasuries. The world has changed massively since then. And there has been some talk that some of the committee would like to get back to an all-Treasury portfolio.

I think some greater clarity on that is going to be required by the markets over time. And I would like to understand what the chair thinks about the composition of the portfolio. If they do want to go back to an all-Treasury portfolio, that's a profound development for the mortgage market. They haven't unveiled that yet. And I think we need to keep putting pressure on them to offer as much insight as they can, going forward on that issue.

RACHELLE AKUFFO: So, Sarah, do we have an idea of where we are in terms of the economic recovery narrative, based on the most recent data, as well as the moves that the Fed is making?

SARAH HOUSE: So, I mean, in terms of their recovery, I mean, obviously, we've seen output has more than recovered. The labor market, we haven't seen jobs recover, but essentially, in terms of overall tightness, we're back to where we were. So I think, in many ways, we've seen this recovery surprise time and time again. And I think overall, we're looking at such a strong economic backdrop. And that's why we do have the Fed embarking on this fastest tightening cycle we've seen since the mid 1990s.

SEANA SMITH: RJ, right now, we do have a hawkish Fed, but there is this risk, though, that inflation could potentially be stickier than what maybe we initially are thinking it could be at this point. How are you positioned, or how should investors be positioned right now?

RJ GALLO: Well, on the fixed income side, across our actively managed portfolios-- and we are an active manager. We don't run passive strategies currently at Federated Hermes. We've been materially short duration for quite some time. Go back a year, nine months ago. Transitory was a pretty hot word. It proved to be a false word. Inflation proved to not be transitory, in fact, to be quite persistent and quite a bit higher than many anticipated. We felt that the inflation problem was going to be more problematic than the market. So being short duration has worked.

We think most of the pain in the terms of the rapid bond market sell-off that has characterized the last five months or so, most of the pain is probably behind us. At this point, the market is expecting a terminal Fed funds rate around 3.4%, give or take. We think that's a reasonable expectation. It wasn't that long ago that number was still in the 2s. So the bond market has incorporated a lot more tightening than the Fed has already done.

And that's because these days, the Federal Open Market Committee, it's almost sort of like the Federal Open Mouth Committee. They communicate their projections, their speeches through very detailed minutes what their expectations are. And the market has repriced to those expectations, given the extremely high inflation. They give a lot of credibility to the idea that the Fed, indeed, will be hawkish. So a lot has been priced into the market. Take the Fed funds-- expect the Fed funds rate well north of 3%.

So I would argue going forward, bonds are still a little tough for investors. And I expect some further upward drift in yields. But we're not as aggressively short as we once were. For a while, we've been favoring floating rate notes and tips. We've turned those preferences down in our portfolios, adding more fixed rate treasuries. It's probably time to get a little bit more incrementally positive on fixed income returns from here after they've gotten bludgeoned really, to be frank, on a year to date basis.