Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
What are the Fed’s possible considerations on rate cuts?
Peter Garnry
Chief Investment Strategist
Summary: The FOMC language yesterday pushing back at the market’s pricing on a rate cut coming in March was a bit of surprise to the market. We go through the various arguments for why the Fed is hesitating on cutting the policy rate and also the key reasons why the Fed should cut the policy rate and continue over the next 12-18 months.
Why is the Fed hesitating on rate cuts?
Did the Fed provide a hawkish or dovish message yesterday in its FOMC statement and subsequent press conference? Some are arguing that it could be both depending on how you look at the message. Judging purely from the reaction in equities the interpretation was hawkish and the market is interpreting Powell’s words that a rate cut is most likely not coming in March. In other words, if the market is right the cutting cycle starts in May. Some are surprised about this development, but there are plenty of indicators suggesting that the Fed should remain cautious and not do a victory lap too early (see below). When we mean cautious, it is not about starting the cutting cycle but at what pace the Fed will go with. Some suggests 250 bps of cuts in the 12 months post the first rate cut in May, but that may be too aggressive if the economy is humming along.
- The US consumer is doing okay under the current interest rate regime with the Redbook Sales Index hovering around 5% implying real growth in consumption.
- The weekly indicators on the US economy suggest that the economy is operating close to trend growth.
- The Atlanta Fed wage growth tracker (median) has steadied now around 5.2% for several months implying an expanding real wage growth which is likely to be a positive forward looking indicator on consumption.
- Companies have generally in the Q4 earnings season been painting a positive outlook in terms of demand.
- Core services inflation (60% of inflation basket) is stilling too high and has increased from 4.5% annualised in August 2023 to 5.2% in December. The slightest comeback to goods inflation could push overall inflation higher again.
- The cooling of the inflation rate is a natural wave effect stemming from more orderly supply chains and base effects making the comparable easier. This means that the next year will begin to finally paint the true denoised picture of underlying inflation.
- The Fed’s own financial conditions index adjusted to the strength of the economy is at levels seen in the years before the pandemic. In other words, credit markets are yet to show stress.
- The policy tightening has only reduced slack in the labour market measured on the job openings / unemployed ratio (this metric has in fact showed labour market tightness in November and December) and not caused a persistent increase in the unemployment rate.
- The US nominal GDP growth is still at 5.8%
When you take all the observations above into account, and combine it with Powell’s previous comments when inflation erupted that the Fed’s models were broken on forecasting inflation, then it is reasonable that the Fed is hesitating to cut the policy rate.
It is all about real rates
What are some of the considerations that the Fed should weight in relation to cutting the policy rate?
- Banks are indicating beginning cracks in the commercial real estate market and easing the policy rate would pre-empt the negative impact. It is important to note that yesterday’s NYCB announcement was related to their rent-regulated multi-family apartments.
- The inflation rate seems to generally coming down and the forward-looking inflation swaps are pricing 2.1% inflation over the next year. Keep in mind though that these markets are not very good at predicting anything.
- But taking the above point on inflation at face value the Fed is significantly restrictive in its policy rate indicated by a real rate of over 300 bps which increases the risk of an abrupt recession.
- With the US government running a 6.5% fiscal deficit over the past year the deficit will for sure come down towards the historical average around 3% causing a negative impulse from government spending over time. Rate cuts will mitigate this negative impulse.
- Monetary policy and credit conditions come with a lag and already now we observe the longest lag in monetary policy since the early 1970s due to the excessive fiscal policies. Acknowledging those lags means that the Fed should prepare for downside risks to the economy in the coming quarters.
- The estimated neutral policy rate according to the Fed is around the 2.5%, so if that estimate is correct the longer the Fed stays above 5% the more pain will follow.
- The long period with low bond yields means that it takes a quite a bit of time for refinancing of debt to kick in, but the refinancing wave is beginning to meaningfully impact credit for companies.
- Geopolitical risks are a downside risk to the economy and are on the rise.
What are some the ways to express your views on the Fed?
If you believe the Fed will start the cutting cycle in May and then go aggressively towards the neural rate then technology, car, renewable energy stocks should be the segments within equities with the highest positive response function to lower policy rates because of their high equity valuations (technology and renewable energy) and high capital requirements (car industry). If one wants to express the view that the economy will cool down fast and that the market is wrong on rate cuts (too few rate cuts priced in) then this is done in SOFR futures. One would be long the SOFR Mar-2025 contract if one believes the Fed must be more aggressive on monetary policy than what is priced in.
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