skip navigation

Kevin Kennedy

The Fed and Liquidity Markets: A Time to Wait and See

Kevin Kennedy
Head of Liquidity Portfolio Management
Julien A. Scholnick, CFA
Portfolio Manager
Matt Jones, CFA
Head of Liquidity Distribution

Inflation has come down over the past year and we think the Fed is nearly finished raising interest rates. The consensus economic outlook has shifted from pessimistic to optimistic, pushing yields up. But we expect slower growth ahead due to tight financial conditions. For the economy overall, we still expect a soft landing absent any unforeseen issues, and the US dollar may weaken after surging to high levels. With yields now at attractive levels, bonds have reverted to their traditional role to once again provide portfolio diversification for investors. Given this environment, we see opportunity to find value in some areas of EM and structured products. Here are some key takeaways.

Market Review

  • Bond yields have risen significantly this year despite improved inflation and a stabilizing Federal Reserve (Fed), driven mainly by growth expectations’ shift from pessimistic to optimistic.
  • The US dollar appreciated substantially through the end of 2022, reaching rich valuation levels compared to history and fundamentals.
  • The Treasury’s extensive debt issuance program since the resolution of the debt ceiling issue earlier this year, combined with other factors including the market’s economic outlook, has caused recent volatility in long-term yields. But we believe this should subside over time.
  • Energy prices spiked earlier in 2022 due to geopolitical tensions, acting as a tax on consumers, but have since moderated to provide some relief.
  • The consumer has remained resilient so far, dipping into savings to maintain spending despite high inflation eroding purchasing power and impacting real incomes.

Fed Policy

  • With inflation coming down, the Fed can afford to be patient before taking further action, engaging a “wait and see” attitude to determine how the economy responds and evolves.
  • T-bill issuance has seen decreased usage of the Fed’s Reverse Repo Program (RRP) by money market investors. This is not seen as a systemic risk, but reflects the relatively higher yields T-bills are currently offering compared to the RRP rate.
  • The RRP continues to be an important component of the Fed’s policy toolkit and ensures yield stability in the overnight repurchase markets.
  • The Fed has been unequivocal that moving to a higher inflation target is not under consideration, while remaining committed to bringing inflation down to its 2% target over time.


  • Inflation has improved significantly over the last year, with core Personal Consumption Expenditures (PCE) down to 2.5% year-over-year from 5.5% a year ago.
  • Supply-chain issues have resolved, the labor market has rebalanced and wages have come down—all factors that should contribute to lower inflation.
  • Lower inflation over the past year is consistent with stable to lower bond yields, not the rise that has occurred.
  • Further labor market improvements on job growth, wages and participation would help rein in inflation, though more progress is needed.

Portfolio Positioning

  • Duration overweight positions have been challenged by the rise in yields, though credit-sensitive sectors of the market benefited from solid economic growth.
  • In both broad markets and liquidity portfolios, our expectations around the likely trajectory of interest rates are that we are close to peak levels and cautious duration extension is appropriate.
  • Our portfolios emphasize high-quality spread sectors while seeking to generate excess income, another source of returns this year alongside duration and value opportunities.


  • We expect US economic growth to slow from the solid pace of recent quarters amid restrictive financial conditions.
  • While a recession is not expected, we think the risk of a harder landing increases the longer rates stay elevated.
  • After surging to rich valuations, we expect the US dollar to moderately depreciate back toward fair value.
  • While nominal borrowing levels and the impact of “higher for longer” rates are expected to drive spread widening in certain sectors, and drive relatively higher levels of default at the lower end of the ratings scale over time, this is not evident among the issuers with whom Western Asset liquidity portfolios invest.

Q & A

  • We expect the Fed to hold rates at the current, high, restrictive level through year-end, with possibly only one more hike in early 2024 before pausing as they assess the impacts of tightening.
  • On the yield curve, we have added exposure on the front end with the Fed nearing the end of hikes, but still see value in the back end given high valuations.
  • Geopolitical risks like slower China/Europe growth are headwinds for the US, while Middle East energy tensions could raise oil prices and hurt consumers.
  • The consumer has drawn down savings to maintain spending levels despite high inflation and stagnant incomes, but this will be hard to sustain over the long term.
  • We think the tight labor market has made good progress at rebalancing supply and demand dynamics and lowering wage growth.

© Western Asset Management Company, LLC 2024. The information contained in these materials ("the materials") is intended for the exclusive use of the designated recipient ("the recipient"). This information is proprietary and confidential and may contain commercially sensitive information, and may not be copied, reproduced or republished, in whole or in part, without the prior written consent of Western Asset Management Company ("Western Asset").
Past performance does not predict future returns. These materials should not be deemed to be a prediction or projection of future performance. These materials are intended for investment professionals including professional clients, eligible counterparties, and qualified investors only.
These materials have been produced for illustrative and informational purposes only. These materials contain Western Asset's opinions and beliefs as of the date designated on the materials; these views are subject to change and may not reflect real-time market developments and investment views.
Third party data may be used throughout the materials, and this data is believed to be accurate to the best of Western Asset's knowledge at the time of publication, but cannot be guaranteed. These materials may also contain strategy or product awards or rankings from independent third parties or industry publications which are based on unbiased quantitative and/or qualitative information determined independently by each third party or publication. In some cases, Western Asset may subscribe to these third party's standard industry services or publications. These standard subscriptions and services are available to all asset managers and do not influence rankings or awards in any way.
Investment strategies or products discussed herein may involve a high degree of risk, including the loss of some or all capital. Investments in any products or strategies described in these materials may be volatile, and investors should have the financial ability and willingness to accept such risks.
Unless otherwise noted, investment performance contained in these materials is reflective of a strategy composite. All other strategy data and information included in these materials reflects a representative portfolio which is an account in the composite that Western Asset believes most closely reflects the current portfolio management style of the strategy. Performance is not a consideration in the selection of the representative portfolio. The characteristics of the representative portfolio shown may differ from other accounts in the composite. Information regarding the representative portfolio and the other accounts in the composite are available upon request. Statements in these materials should not be considered investment advice. References, either general or specific, to securities and/or issuers in the materials are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendation to purchase or sell such securities. Employees and/or clients of Western Asset may have a position in the securities or issuers mentioned.
These materials are not intended to provide, and should not be relied on for, accounting, legal, tax, investment or other advice. The recipient should consult its own counsel, accountant, investment, tax, and any other advisers for this advice, including economic risks and merits, related to making an investment with Western Asset. The recipient is responsible for observing the applicable laws and regulations of their country of residence.
Founded in 1971, Western Asset Management Company is a global fixed-income investment manager with offices in Pasadena, New York, London, Singapore, Tokyo, Melbourne, São Paulo, Hong Kong, and Zürich. Western Asset is a wholly owned subsidiary of Franklin Resources, Inc. but operates autonomously. Western Asset is comprised of six legal entities across the globe, each with distinct regional registrations: Western Asset Management Company, LLC, a registered Investment Adviser with the Securities and Exchange Commission; Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários Limitada is authorized and regulated by Comissão de Valores Mobiliários and Brazilian Central Bank; Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services License 303160; Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services License for fund management and regulated by the Monetary Authority of Singapore; Western Asset Management Company Ltd, a registered Financial Instruments Business Operator and regulated by the Financial Services Agency of Japan; and Western Asset Management Company Limited is authorised and regulated by the Financial Conduct Authority ("FCA") (FRN 145930). This communication is intended for distribution to Professional Clients only if deemed to be a financial promotion in the UK as defined by the FCA. This communication may also be intended for certain EEA countries where Western Asset has been granted permission to do so. For the current list of the approved EEA countries please contact Western Asset at +44 (0)20 7422 3000.