Branstad: Hi, everyone. Thank you for joining us today for Thrivent Asset Management’s Capital Markets Perspective. I’m Jeff Branstad, your host for today and a portfolio manager here. I’m joined by Steve Lowe, our chief investment strategist.

Alright, so, let’s try to put yourself in the Fed’s shoes. What are they thinking right now? What kinds of things are they looking at?

Lowe: Well, in a nutshell, they’re trying to keep rates high for a long time until inflation is beat to their satisfaction. They’re most likely done hiking rates – there’s a chance of one more hike. And if inflation proves a little stickier, they may hike again. Looking at the market, there’s less than a 50% chance of another hike priced in as we talk, and then about three cuts through 2024 – that’s more than the Fed expects.

Our own view is that the Fed will ultimately need to cut sometime next year due to a slower economy or just because inflation will have come down enough.

Branstad: Alright. So, Steve, one of the things that we just keep talking about over and over on here which has been mentioned again is inflation. Let’s dig into that a little deeper.

Lowe: Yeah. Inflation has really driven this whole market cycle. It’s the reason the Fed is raising rates. So, inflation is coming down. That’ll enable the Fed to pause. It’s fallen pretty significantly. Headline CPI, with energy included, fell from a little bit below 9% to around 3% currently. That tends to be more volatile. Core inflation, which takes out energy and food, has fallen from about 6.5% to 4%. So, there’s progress there.

But the Fed isn’t going to declare victory yet because there are very sticky elements of inflation. In particular, they focus on service inflation. What they’re really worried about is wages feeding into inflation, then people demanding more wages. So, you get this spiral. The Atlanta Fed has a wage growth tracker which is at about 5.3% or so right now.

I still think broad inflation should fall. Housing is a large part of it and that’s been a little slow – it’s definitely coming down. But if you look at one risk for this all, that’s energy. That’s kind of a wildcard, because if oil moves up, it’s going to feed into headline inflation and then ultimately through all of inflation.

So, the bottom line is it’s encouraging. I think the Fed is going to be cautious and slow to cut, but the trends are good.

Branstad: So, let’s talk a little bit about interest rates, then. With the Fed raising rates, the front-end of the curve has gone up, but the back-end – the longer-term rates – have also risen quite a bit. What have been the drivers there?

Lowe: As we talked about, that’s had a big impact on markets. It’s not really inflation expectations – you can look at inflation expectations and various market measures of that, and those have changed very little.

The higher-for-longer rates approach of the Fed is a bit of it, but the Fed funds rate affects short-term rates more than long, like the ten-year Treasury rate, because it itself is a short rate.

I think it’s a variety of different things. One of them is that we’re running very large deficits right now, so there’s a large supply of Treasuries hitting the market and you need to entice people to buy, particularly buyers of higher rates.

I think another part of it is that you still have what’s called quantitative tightening happening – so, the Fed is reducing its balance sheet pretty significantly. It’s already lowered Treasuries on its balance sheet by about $1 trillion.

But a lot of it is this concept called the “term premium” which is the imputed risk premium for holding Treasuries – where are rates going to be long term, what’s inflation going to be, volatility – and that has gone up a lot. That’s what’s driving real rates – or inflation-adjusted rates – higher. It’s the highest since 2007.

The end result is that real rates in particular are going up, and that, as we’ve talked about, impacts the market – it impacts equity valuations. It can drive P/E ratios down, or valuation ratios. Markets can digest higher rates for a while, particularly if growth is going well. But we kind of hit a tipping point in the third quarter going into the fourth where higher rates were starting to have an impact, particularly leading to growth concerns – they’re getting too high for the market.

Branstad: So, Steve, what are what are your expectations for rates going forward?

Lowe: I think we’ve probably seen the peak, or we’ve gotten very close to the peak. Inflation is going down and growth should slow – that would cap rates. If you look at the short part of the curve, like a 2-year Treasury, that’s probably at its peak right now. The only way that’d go higher is if inflation picks up and the Fed needs to raise rates more.

But our expectation is that, ultimately, the curve will still steepen because cuts start getting priced into the market for the Fed.

Branstad: – so that long rates will have peaked and then eventually we’ll start to get the short end coming down.

Lowe: Exactly.

Branstad: Well, thank you so much, Steve, for sharing Thrivent’s perspective on the capital markets. And thank you all for joining us today. We’ll see you again soon. Thank you.

Lowe: Thank you.