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Reactions to the April FOMC - High Quality Credit Spreads

FICC Podcasts April 29, 2021
FICC Podcasts April 29, 2021

 

Dan Krieter and Dan Belton discuss their takeaways from the April FOMC meeting and press conference which largely centered around the Fed’s dual mandate of full employment and stable prices, the potential for regulation of the non-bank financial sector, and financial stability concerns. Dan and Dan then discuss the reasons behind the recent change in their view on credit spreads.


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About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

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Dan Krieter:

Hello, and welcome to Macro Horizons, high quality spreads for the week of April 28th, reactions to the April FOMC. I'm your host Dan Krieter, here with Dan Belton. As we discuss our takeaways from today's FLMC meeting, and provide a quick overview of recent developments in the credit spread market.

Dan Belton:

Each week, we offer a view on credit spreads, ranging from the highest quality sectors such as agencies and SSAS to investment grade corporates. We also focus on us dollar swap spreads and all the factors that entails including funding markets, cross currency markets, and the transition from library to sulfur. The topics that come up most frequently, in conversations with clients and listeners, form the basis for each episode. So please don't hesitate to reach out to us with questions or topics you would like to hear discussed. We can be found on Bloomberg or emailed directly at Dan.Krieter- K R I E T E R,Dan.Krieter@Bmo.com. We value and greatly appreciate your input.

Speaker 3:

Any views expresse here are those of the participants and not those of BMO Capital Markets it's affiliates or subsidiaries.

Dan Krieter:

Well Dan, I think affectations were quite low coming into this fed meeting, and certainly the committee did not disappoint on that front. Starting specifically with the statement. I don't think we have to spend almost any time here. The statement was essentially unchanged from last month, some minor tweaks here and there. Nothing I think worth talking about, there was no change to the feds administered rates are our peer IOER, even the press conference. I mean, I took some notes there. I think there are some things worth discussing, but compared to previous fed meetings, I think even the press conference wasn't as exciting this time around, but before diving into some of those specific topics, I guess, just from a high level, what were your takeaways?

Dan Belton:

Yeah, about the same. I thought it was one of the less eventful FOMC meetings that we've had in some time. I thought chair Powell, tilted dovish, for sure. I think there's been a lot of economic optimism baked in, and I think that was apparent in the statement, like you mentioned, there weren't many changes to the statement, but I thought most of the changes are generally referring to improvements in the economic outlook. There was talk about growth in the employment picture, improvements in sectors that have been most impacted by the pandemic. Then inflation has ticked up even though it's due to transitory factors. So a lot of optimism there, but then chair Powell starts out his press conference with the question, is it time to start talking about tapering?

Dan Belton:

And he said, no, it's not. And we'll let the market know, but we're still making progress towards these goals. And it's not yet time to start even thinking about tapering. So I thought that was pretty dovish, not necessarily a surprising answer. I think we probably could have guessed that, that's where he would have gone with that question, but still notable. Nonetheless, given that economists have started to push forward expectations for tapering with many expecting it within the next six months or so.

Dan Krieter:

Powell stance sort of stops that creep. It's sort of been creeping in people talking about tapering earlier and earlier. And I think the chair, like you said, it doesn't come as a big surprise, but he came up pretty forcefully and said, we're not even starting that process yet. And that process is going to take months as we all know. So that was my first note as well. Then, you know, we always entitled these episodes reactions to the FLMC, but if we didn't, I would have certainly entitled this episode base effects and bottlenecks because seemingly the majority of the press conference after that first question was focused on inflation in some flavor. Just what if inflation is getting away or how do we know about inflation and blah, blah, blah. And the chairman just kept harping over and over again on the base effects that are viewed as transitory, as well as supply bottlenecks that are likely to pay transitory.

Dan Krieter:

We can't know that yet, but the fed at least initially is going to be viewing them as transitory and any increase in inflation that we are definitely going to see in the next few months is going to basically be thrown out the window. So nothing surprising on the inflation front though, I did make one note, Powell really seemed to be harping on the role that wage inflation is going to take in any sustained inflation that comes out of this. I think it was actually the second question where he was asked something about inflation expectations, possibly taking off. I don't remember the exact wordage, but his response was something like inflation expectations really can't increase without labor slack dwindling, or there's a very low likelihood that, that will happen. We need to see that labor market slack come down before sustained inflation can take its place.

Dan Krieter:

The obvious implication here being wage inflation. Then later in the press conference, you got a different question, which I find interesting. It was a question on increased reports of businesses being unable to find workers as the economy reopens that there aren't people to go to work. And I think Powell had three interesting takeaways from that. The first, at least interesting to me was that he made it seem more widespread than I guess I thought or realized. And I haven't done a significant amount of work into it, but he made it seem like, oh, the fed has the longest, largest network of business connections and I'm sure that's true. And he said that this is something that you're hearing commonly, that there's a lot of reports of businesses being unable to find workers. So I thought that was notable.

Dan Krieter:

Two, he noted that it was not being accompanied by any noticeable increase in wages or any evidence of wage inflation, at this point. There's probably a lot of explanatory factors that maybe we can talk about it later in the podcast, but I think that's worth noting there.

Dan Krieter:

And then third, and what I want to focus on here is that he started talking about potential drivers of this labor shortage and he listed, I didn't have time to write them all down here, but it had to be five or six, things like geographical dislocations and not having the right tools at training mismatch there. I don't remember them all. And didn't mention anything about stimulus until the very end. He sort of said something like, well then also extraordinary unemployment benefits expire in September. So "to the extent that, that's a factor", that should start to fade in the next few months. So to the extent that, that's a factor, I personally think that's a huge factor, but what did you take away from that?

Dan Belton:

Yeah, I thought that was interesting. And I certainly noted this answer to the question as well. In terms of the job mismatches, I wrote down skills mismatches, you said geographical, there's also been virus concerns that have been keeping people out of the labor force. And then he also talked about people who have said they've retired since the onset of the pandemic, but that he expects them to some degree to return to the labor market. And then of course the unemployment benefits running out in September. So I thought just taken all of those things together. It was interesting. Chair Powell clearly believes that labor force participation is going to start coming back over the next six months or so. And it'll be interesting to watch that and what implications that has for labor market slack.

Dan Krieter:

Yeah, because he said at least five times throughout the press conference, 8.5 million people are without a job that had one before. And yet we're seeing this slack and yeah, I get that there are certainly other factors. You mentioned the virus. I forgot about that one. Certainly some people are worried about going back to work. I think the chair talked about schools not being open yet, and that potentially restraining some people for being able to return to the labor force. But if you have all these sort of obstacles that when we're talking about geographical mismatches and skills mismatches, we're not talking about cyclical unemployment here, that's structural unemployment. So we can just sort of file that into a different category. So then the cyclical unemployment should be these near term frictions that are then over time, theoretically resolved. And even to some extent, structural unemployment can be cured over a long period of time.

Dan Krieter:

But, if there is all these either short or long-term barriers to employment, that would say to me that if we're going to see wage inflation, we should be seeing some, and we're really not. And I guess to broaden that out, there's a few different things to take away. You said at the beginning that the fed was very, very dovish. And I think that's the case. I mean, we're already on record as saying, we're going to miss to the highest site on inflation for a significant period of time. That was a major shift last year by the fed.

Dan Krieter:

But if we're not seeing wage inflation, it worries me for the long-term view on inflation and then to look at it from the employment side, once again, Powell took time during the Q and A to mention, the unemployment rate in minority sectors. And I think obviously there's disagreement here, but I think that in the current cycle, the fed is going to take a more explicit view on not just minimizing unemployment, but also minimizing unemployment in minority sectors as well. And if that's the case, you can make an argument here that the fed is going to remain dovish, not just on the inflation side, where inflation is going to run hotter than previous feds have ever let it. But they're going to let employment run hotter than ever before, pushing down into the low single digits, theoretically, to try and bring down specific targeted unemployment rates.

Dan Belton:

Yeah, Dan and I think that just goes to the feds view of the labor market, looking at it more holistically, as opposed to just looking at the unemployment rate. And that's been a change that we've seen over the past business cycle where they've emphasized other things, then the unemployment rates such as the underemployment rate, we've seen increased talk about labor force participation. More recently, we've seen talk about unemployment rates among different groups.

Dan Belton:

And that just goes to the Fed's view that it's not simply about this one unemployment number. It's really about more broadly eliminating slack in the labor market. And to me that implies that it gives the fed a little bit more room to let the labor market get hotter and hotter because even as the unemployment rate gets low, they can find other pockets of the labor market to point to and say, there's still slack and we can keep rates low. We can expand our balance sheet, et cetera. So, that just is another dovish tilt to me from today's press conference. Again, it's not something new, but it's just more of the same emphasis on broad labor market slack that the Fed's trying to eliminate.

Dan Krieter:

Yeah and again, just to hammer the point home. The fed has a massive [inaudible 00:09:29] they could deploy at any time to combat inflation where they ever to get it. And he said that again in today's Q and A, don't think we won't fight inflation if we ever need to. And they certainly have a lot of weapons to do that. They don't have as many weapons to fight against continued slack. It's just pretty clear to me that the fed is going to be extremely, extremely accommodating for a long time. Probably even more accommodative than what the market is currently pricing, which is pretty extreme accommodation. But yeah, now I think we've probably covered that topic sufficiently.

Dan Krieter:

So moving on to the next thing, Powell talked a bit about digital currencies from central banks probably don't need to spend time there. I guess, for the rest of the press conference, it was really two main themes that I think worth talking about the first being financial stability and the second on the regulation front, let's start with financial stability because I think that there's less to talk about here, Dan, anything you saw with taking away? Yeah.

Dan Belton:

Yeah, he went through those four pillars that we talked about, I think after the last press conference where he talked about the status of each of those, as it relates to financial stability and of those four pillars, just as a refresher, he talked about leverage in the financial system, funding risks, asset prices and the household sector. And of those four, he said three we're in pretty good shape leveraging the financial system. He said, it's not an issue. Funding risks are currently low. And then he said, the household sector is in pretty good shape and it's been supported by fiscal stimulus. He did acknowledge that asset prices are potentially a problem here. He said that things are a little bit frothy and was more forthcoming about the Fed's role and elevated asset prices than he had been in previous press conferences. Overall. He said that the financial stability picture is mixed but manageable. So I thought that was an interesting takeaway.

Dan Krieter:

Yeah, interesting. Not the first time he's insinuated some degree of exuberance in asset price markets. I think, I can't remember exactly. I feel like this is the first time he said the word froth, which I thought was interesting, but he's hinted at there being potentially some asset price overvaluation in asset prices in the past few sessions, nobody's cared. I don't think that is going to change this time around you talk about all four pillars of the Fed's framework for financial stability. And one of them being funding risks, which you said are very low, but then you said there is some concern in the money market fund space. I wasn't sure what to make of that at first then I guess it became clear to me. We started talking a bit about regulation and then I understood what he was talking about. So on the regulation front, what I actually thought was the biggest takeaway from today's press conference.

Dan Krieter:

He fielded two separate questions, really on regulation. The first one was related to how do you say it? Our Chagos I've been saying Archer GOs and probably will continue to serve for the rest of the podcast. So I apologize, but the first one was relating to Our Chagos. And I guess it was a question regarding basically how the fed missed this. And the chair said, you know, we don't run these banks for them. We supervise to make sure they have the tools they need to be able to oversee. We don't run their business for them. It looked like there might've been some breakdowns in risk management. Some of them, not all, some banks and it ended up being something that was not systemic. The numbers were not big enough. So basically just saying this wasn't our fault, but he did not specifically mention regulation at all here, which was my takeaway at first.

Dan Krieter:

But then later he got a direct question on regulation and he took it and kind of two different ways. First he talked about capital requirements on banks. Secondly, he talked about non-bank financial intermediaries and quickly on banks. He basically said bank capital's good. It's gone up significantly in the last 10 years as Basil 3 regulations were implemented. It's withstood stress tests and obviously the COVID-19 events. So bank capital's in a good place.

Dan Krieter:

Then he talked a bit about regulation on the non-bank side, which our listeners will know as a theme we've been following here for the past couple of fed meetings. So this is something I was particularly keyed in on. And for the first time he said that during March of last year, he specifically identified money market funds and corporate bond funds as exhibiting "run dynamics". And he was talking so fast I couldn't write it all down here, but he said something like they can't just count on the fed and other central banks to step in.

Dan Krieter:

They have to have the wherewithal to stand on their own and that the fed and other global regulators are looking at reform or ways to structure them. I can't remember exactly what he said. I didn't have time to write it all down word for word, but that was the high level takeaway. Again, insinuating that there will be some more regulation coming for non-bank financial intermediaries, but then specifically talking about corporate bond funds. And I think that's really important when you think about the role that leverage has played in bond funds for the past couple of years, specifically with rates very, very low and what that could mean going forward.

Dan Belton:

That was definitely one of my bigger takeaways too. And as you mentioned with rates so low, there's just been an increase in leverage throughout the financial system and certainly has been a big part of corporate bond funds as well. So that's definitely something to keep an eye on going forward. I think for any further breadcrumbs from regulators, including the fed on that topic. And then he also talked about treasury market structure and selling by foreign central banks last March. And he alluded specifically to some regulation that might be in the work specifically that is being led by treasury.

Dan Krieter:

Yeah, certainly he talked about treasury market structure and talk about how the foreign central bank selling last year, really overwhelmed dealer balance sheets, and the fed had to step in and they talked about how treasury supply is going to be larger going forward. And the, basically that the street has to be able to intermediate large flows. And so two things of note that he said, and this is a direct quote, "treasury is going to be leading this", which to me made sound like something's in the works and Treasury's leading it. So something's coming down the pipe, who knows what. He also said, something like, is this the type of tailor risk something's coming from treasury. But then that made me think about the SLR and thinking about treasury exemptions on the SLR. If the fed knows that bank balance sheets aren't as able to intermediate flows, certainly part of that is because the leverage ratios right, and giving that treasury exemption maybe helps the market liquidity there.

Dan Krieter:

So the chair didn't connect those two. That's me doing that. But his comments made it seem just slightly more likely to me, you know, we've been talking about the permanent SLR exemption that's coming as potentially being just reserves and not reserves and treasuries, after the chair talked about this specifically. Well, he didn't really have to, it seemed to it, the question that he was asked, it just made me think that maybe the SLR exemption will be reserves and treasury, just a little more than I already did.

Dan Krieter:

Just two more quick topics, stand from the FLMC. Want to get your thoughts on housing. It was seemed to be a relatively common theme throughout and specifically one question that I thought was a good one. Talking about while you said earlier in the press conference, that housing conditions are quite good. We're seeing huge growth, blah, blah, blah, blah. But we're also buying $40 billion a month in MBS. Doesn't totally seem to match up. So did you have any thoughts on Powell's stance on housing?

Dan Belton:

Yeah, I thought Powell seemed pretty constructive on housing overall. He talked about how people borrowing have good credit and there's not a housing bubble, even though housing prices continue to go up, he made it seem like it was more of a supply issue than anything else. He said that over time builders are going to start to catch up with supply and that it's going to find its equilibrium. Then in the fed buying mortgage backed securities, that was a question that I was kind of waiting for, for this press conference, for someone to say, look, the market and the economy are chugging along. What is the need for the Fed's continued involvement in the market? And I don't think we got much from Powell on that topic specifically. Not that we're expecting any insights from him on that, but I just thought it was an interesting question and an interesting [inaudible 00:16:52] position that the fed is still buying a lot of mortgage backed securities while the housing market is really booming.

Dan Krieter:

Yeah. I agree with you. And finally, the last topic that I guess we should talk about here is just the short end. The RRP IOER debate. I think actually heading into a, not highly anticipated fed meeting, this was maybe the thing people were looking most forward to. And those people were certainly disappointed, not just because the fed did not make any adjustments to those rates, but because it didn't even seem like they were close. They did get one question out of the Q and A and chairman Powell really couldn't have cared much less. Huh? Fed funds rate is still comfortably toward the middle of the range, he said. Downward pressure on the short end, they expect to continue as TGA continues to put downward pressure on short rates. But at the end of the day, he said, conditions were "fine". And that they saw no need to make those adjustments at this time.

Dan Krieter:

They will do so if that need does arise, but I mean, there's no need at this point. It's hard to see when that need will be. I mean, we see our RP usage up over 120 billion now. So for one basis, point for months,.Dan, what could you even foresee as constituting a need for the fed to step in at this point? Like what more could happen?

Dan Belton:

No. Yeah, you're right. And I completely agree. It's just going to be a matter of fed funds, it seems like. As long as fed funds remains above five basis points from the bottom of the range, currently five basis points, as long as we're still there, and Sofer is positive, even if it's continues to set at one basis point with continued downward pressure. I don't see the fed making any moves here. I think the chair was pretty specific today that the fed funds is the policy rate and that is going to be the impetus for us to use our tools.

Dan Krieter:

And if that's the case, we may never see a technical adjustment. I mean, fed funds has been seven basis points now, I'd have to look to know exactly, but for a long time, you know, for the majority of the time, I think, or maybe all the time that SOFIS dropped to one basis point except for one day. And that one day was month end March. And you know, we're hearing some pressure this week that fed funds is maybe trading lower than seven and might actually print lower than seven. But again, we're heading into month end when it's a well-known dynamic that foreign banks in the U S start to look at doing window dressing, particularly European banks, and they reduce their demand for fed funds. So that rates starts to drop. But then as soon as month end or quarter end passes, you know, that demand comes right back and it's still, even at seven basis points the cheapest source of unsecured funding for a Yankee bank.

Dan Krieter:

And there's going to be that demand at seven. And you know, it's certainly not out of the realm of possibility that it drops these seven, but it hasn't happened yet. And to me, that's sort of the biggest indication if it hasn't happened yet, what's going to drive that, you know, outside of a transitory month end type thing. And I think we'll need more than that. And so we came into this, not expecting any technical adjustment and I'm starting to think we might not get one at all, frankly. So we'll keep our eyes on it, but certainly doesn't seem like it's coming anytime soon. Dan, anything else on the fed before we just wrap up with a brief overview on credit?

Dan Belton:

No, those were the big things. There were a couple other notes, but nothing that I think warrants much further discussion. I think we've covered most of the important topics today.

Dan Krieter:

Well, in that case, you know, looking down, we've been talking for a while already, so maybe we'll just try to keep this relatively brief, but just wanted to give an update on credit. And the update is there is not much of an update spreads continue to trade in a very, very narrow range. Yesterday closing at 88 basis points, so within one basis, point of cyclical lows. But perhaps the lack of volatility is in itself notable. In fact, it's historical. Isn't that right?

Dan Belton:

Yes. So spreads have been in a four basis point range over the month of April, which is actually the tightest range that credit spreads have traded in since April of 2017. So, you know, this continued lack of volatility. It's not clear what's going to break us out of this range. I think it's probably going to be technically driven, but there are some risks on the horizon that we've been talking about increasingly, and I've actually driven us to remove our preference for triple B rated debt. Yeah.

Dan Krieter:

I moved to neutral at the end of the, it looks good now that we've had the least movement in four years in a single month, but that's not really what we were getting at. It was just saying that there's just not upward potential in spreads. At this point, we're at cyclical lows. We're very near historical lows. All-time lows of 84 basis points, which by the way, came, when rates were much higher. And it just really can't see much impetus, this spreads narrowing, like there's already so much optimism built in on the economic reopening that actually the economic reopening might be somewhat of a headwind, to be honest with you. Because if we think about what can happen when the economy reopens fully one of three, things is going to happen.

Dan Krieter:

The first is that in some way, disappoints people don't return in the way they did things are permanently changed.

Dan Krieter:

Whatever. However you want to look at it, the recovery disappoints. If that happens, yes, we'll see treasury rates rally. But to me that weaker economic recovery scenario comes inextricably with renewed fears of downgrades and defaults. Like if this economic recovery isn't going to be robust enough to support business, what is, you know, so you're going to have downgrades and defaults, which should at least lead to transitory spread widening. Even if ultimately spreads can go lower later in the cycle. The second scenario is, all the optimism built in, is met and then some, and we see inflation take off in a way that we haven't seen in 20 years. Certainly possible with where we are and how much accommodation is in the system. But if that happens, we're going to see treasury rates go much higher, spreads go higher mechanically as a result of that. But then also, you know, there's much has been made about the refinancing fears and what it could do for corporations that have grown reliant on cheap debt for the better part of the past decade.

Dan Krieter:

You'll see that conversation reignited with higher rates and also a spread widener.

Dan Krieter:

Then the only scenario, the third scenario is what I call the Goldilocks scenario, where you see a robust economic recovery with inflation, even going as high as 3%. But that being viewed as manageable, treasury rates stay stable, sort of softly, slowly go up and you see credit outperform on improving technicals. It's possible. This is a scenario, but it's the price to perfection, the Goldilocks scenario. And I think it's a narrow path there and I just don't think it's very likely. So from that standpoint, it's hard to see spreads going much narrower, but at the same time, it's going to take time for all this stuff to happen. So the neutral stance, I like, we keep that that way, but we've been over-weighting triple B's this whole time because, well, we didn't see much upward potential.

Dan Krieter:

There wasn't much risk of anything causing significant spread widening. So we still wanted to at least get extra yield, extra carry while we sat in this range. The move away from the triple B overrate at this point reflects not much of a change in our view and from a macro standpoint, as much as it does just the increasing odds that something happens that could cause a spread widening. And that could be something like more speculation on non-bank financial intermediary regulation or talks of tapering or what have you. It's not immediately clear, which is why we don't think it's a high likelihood, but given how widespread vaccination rates now in the US, how high they are. And, you know, we're sort of getting close to that period of time, we're going to start seeing actual data. It just seems like the risk is getting higher to me. And what we've seen in the past is that spreads, at least over the past decade, they don't necessarily grind wider. They tend to grind narrower, but then you see these transitory kind of quick, repricing's wider. Isn't that right?

Dan Belton:

We wrote about this on Friday. And the way that we presented it, was we looked at spreads versus their 90 session moving average. We found that credit index spreads tend to trade narrow of their moving average on 66% of days. Now, what this implies is that spreads are generally moving narrower over a long period of time. And then they shoot wider during periods of relatively intense risk off. So we highlighted just four such periods of risk off since the financial crisis and noted that during other times, spreads are generally on a often multi-year trend lower. And I think this just goes to show the asymmetric risk profile to spreads, particularly as they trade right now at the bottom end of trading ranges. Sure. Spreads could continue to compress and move slightly narrower over the next several months. But as you mentioned, there are significant risks on the horizon, including potential for regulation, tax increases, fed tapering and all the potential to send spreads wider and a sharp risk off fashion.

Dan Krieter:

Yeah. And the final piece of the puzzle, you alluded to it as relative value. I mean, we've been favoring triple B's and sectors exposed to the opening for a while now, but any relative value that was left in those sectors has been pretty much wrung out. You know, we took a look at our heat map that sort of tracks the credit spread relationships all the way across the credit spectrum. From the very, very top SSA's and agencies down to high yield triple season, what have you, and, you know, it's not going to come as a surprise to everyone here that spreads are tight. But the potentially interesting part is the further out the credit spectrum you go, the tighter it gets. I mean, it was a uniform shift in color from less red to dark red, the further down the credit spectrum you went. So just with how much spreads have performed and risk factors, potentially starting to gather on the horizon and RV really solidly favoring up in credit moves.

Dan Krieter:

At this point, it just made sense to us to move up in credit over the period of the next couple of weeks, where we expect things to stay relatively range-bound and position a portfolio for a very short-lived burst wider at some point in time over the summer, likely that we can use to just get a better buying opportunity and look to reset longs there. Because it's not going to be a significant move wider, we're not talking 30 basis points or anything most likely, but there's just not a ton of value in spreads right now. And we think there will be better value in the months ahead.

Dan Krieter:

Dan, I think that about wraps it up unless you have anything else you want to add.

Dan Belton:

No, I think that does it. Thanks for listening.

Dan Belton:

Thanks for listening to Macro horizons. Please visit us at BMO CM.com/Macro horizons. As we aspire to keep our strategy efforts as interactive as possible. We'd love to hear what you thought of today's episode. Please email us at Daniel.Belton- B E L T O N, Daniel.Belton@Bemo.com. You can listen to this show and subscribe on apple podcasts or your favorite podcast provider. This show is supported by our team here at BMO, including the FIC macro strategy group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

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Dan Krieter, CFA Director, Fixed Income Strategy
Dan Belton Vice President, Fixed Income Strategy, PHD



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