Eric Hathaway, Senior Portfolio Manager on the BlueBay U.S. Fixed Income Team, discusses how the market rallied after the Fed signaled that they view inflation as under control and it’s therefore time to cut rates.
Watch time: 4 minutes, 13 seconds
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Hello and welcome back to The Weekly Fix. My name is Eric Hathaway, Portfolio Manager with RBC Global Asset Management’s BlueBay Fixed Income Team.
“The time has come”. Those were the words Jerome Powell used in Jackson Hole last Friday to signal to the market that he was finally ready to embark on the easing campaign that investors have been so eagerly anticipating for more than a year now. The key in getting to this moment was the committee gaining sufficient confidence that inflation was tamed, and no longer a persistent concern. He said, “My confidence has grown that inflation is on a sustainable path back to two percent.” And as well he should have confidence. Core Consumer Price Index (CPI) has fallen to 3.2%, down from 5.7% at the beginning of 2023. The fed’s preferred gauge, Personal Consumption Expenditures (PCE) is at 2.6% on a year-over-year basis. Very close to the target of 2%.
So where does this leave us? Well, the fed now has a new enemy. They are no longer hyper focused on squashing inflation. And so, as long as these metrics behave and continue on a reasonable downward trajectory, the fed is free to turn its focus to the other side of the dual mandate: the labor market. Powell said in his speech, “The Fed does not seek or welcome further cooling in labor market conditions.” Part of this comment was for political purposes – he does not want the Fed to be seen as having contradictory goals coming into an election. But mostly he’s signaling that the focus has now shifted to maximizing employment, and that labor market data will now be most important as the committee sets monetary policy.
Now that Powell has said in no uncertain terms that easing will begin, the question turns to how much and when. On Friday the market was ecstatic about the speech, and bonds and stocks rallied hard. The two-year note fell 9 basis points to 3.91% and the S&P was up over a percent on the prospect of lower rates. Fed Funds futures are now pricing in slightly more than four cuts over the remaining three meetings this year. Of course, that means one of those meetings will see a 50 basis point cut. Our view here is that the market may be a bit too exuberant about lower rates, and that we will likely see two or three 25 bps cuts this year, but a 50 basis-point cut is unlikely. We think that the labor market would have to deteriorate significantly for the Fed to accelerate to a jumbo-cut at one meeting, and that their preferred posture would be steady and measured cuts of 25 at every or every other meeting.
Looking elsewhere in the market, Jay’s performance at Jackson Hole furthered the risk-on tone. Nominal spreads on current coupon mortgages rallied to their tightest levels of the year. Corporate bond spreads were 5 basis points tighter, within 5 bps of their year-to-date tights. High yield was a similar story, 10 basis points tighter on the day. These trading levels imply that the market has high conviction about a soft landing. The data certainly suggests that is possible. However, it is important to remember that this Fed has merely shifted which data it is dependent on. Rather than inflation figures, the market will now hang on any economic release having to do with the labor market. It’s worth remembering that nonfarm payrolls can be a volatile series, with figures in 2024 having a standard deviation of 74,000 jobs, rising as much as 310,000 and as few as 108,000. There will undoubtedly be bouts of higher volatility as those stats are digested.
And with that I’ll wish you success in the markets this week and thank you for attention on another edition of The Weekly Fix.
Summary points
Jerome Powell signaled to the market that he was finally ready to embark on the easing campaign.
As long inflation metrics continue on a reasonable downward trajectory, the fed is free to turn its focus to the labor market.
Chairman Powell is signaling that the focus has now shifted to maximizing employment.
Fed Funds futures are now pricing in more than four cuts over the remaining three meetings this year, but our view is that the market may be too exuberant.