Vanguard's Narayanan: Expect 'Backloaded' Rate Cuts

Don't expect the Federal Reserve to touch interest rates at the end of the two-day Federal Open Market Committee meeting that kicks off today. For that matter, keep your hopes down for any cuts this year.

That's the view of Arvind Narayanan, manager of the $4.2 billion Vanguard Ultra-Short Bond (VUSB) exchange traded fund, who says the central bank will likely backload its interest rate cuts this year, if it cuts at all.

Narayanan says economic data remains too strong for the Fed to cut, with consumer demand keeping up and the likelihood that industrial production will pick up. The three-year-old ETF, which is typically a vehicle for declining interest rates, has pulled in $133.8 million this year, according to etf.com data.

“The U.S. consumer is in a really good spot. We think that companies catering to them, therefore, are also in a pretty good spot," Narayanan said. "There's certainly rationalization of spending happening, and various income cohorts within the consumer bucket are skewing their spending differently, so we need to be mindful of that."

Narayanan also expects industrial output to increase after many manufacturers destocked in 2023’s second half. With inventories drawn down, companies will need to rebuild supplies, something very constructive for the job market and consumers.

Slowdown, Rate Cuts, Unlikely Any Time Soon

That means it’s unlikely the economy will decelerate enough to give the Fed the confidence that inflation will fall at the same pace as it did last year.

“We've always believed that this last mile of inflation is going to be a little stickier and a little bit more troublesome to bring down,” he says. “Our view has always been depending on the data, cuts are going to be backloaded, if any.”

Narayanan says Vanguard expects a higher terminal Fed Funds over the medium to longer-term, as returning to the Fed’s 2% inflation target will be difficult. A core personal consumption expenditures price index between 2.5% to 3% is more likely and if it’s over 3%, that will be troublesome for the Fed. Not that Narayanan is looking for rate hikes anytime soon.

“Data needs to be significantly more hawkish, that inflation would need to show an acceleration from current levels, back to levels that we saw in the last couple of years. That's not our base case,” Narayanan says.

Persistent tight monetary policy continues to reward investors in the shorter end of the yield curve. VUSB has benefitted from rate-cut expectations being pushed out. The actively managed fund, Vanguard’s first active bond ETF, invests in investment-grade securities and aims for a dollar-weighted average maturity of zero to two years. It has an effective duration of just under one year.

It seeks to outperform the one-year Treasury bill, and its portfolio is a mix of investment-grade corporate bonds and securitized credit, at 62% and 23% of the holdings, respectively, along with a smattering of government bonds and cash and equivalents. It has a 5.1% Securities and Exchange Commission yield and a 0.10% expense ratio.

“Marrying credit exposure with duration exposure through a full cycle leads to better investment returns, better risk-adjusted drawdown, so just a better combination of risk factors,” he says.

In the corporate bond space, the fund favors the largest banks in the banking sector, and high-quality industrial companies. In the securitized market, the fund owns high-quality auto loans, those in the AAA-tranche of securities, which is helping to boost yields.

Looking ahead, if the Fed is forced to hike because inflation hasn’t come down, that could push the economy into a recession, so VUSB will scale back its credit exposure. Conversely, if the Fed becomes proactive about cutting rates, talking up the likelihood of cuts as it did last fall, that will be very constructive. In that environment, “we think this fund, with the combination of credit and duration, will do extremely well,” Narayanan says.