After a brief pause in June, the FOMC announced its 11th rate hike of the current cycle on July 26, and Fed Chair Powell struck a more neutral tone in the press conference
Market pricing has become more aligned with Fed guidance for 2024 interest rate policy, but any deviations from both near-term and long-run expectations will have implications for the level of rates and the slope of the yield curve in the coming months
The recent economic data trend has revived the ‘soft landing’ narrative in financial markets
The FOMC announced its 11th rate hike of the current cycle on July 26, raising the fed funds target range by 25 basis points (bps) to 5.25%-5.50%. The official statement from the meeting was essentially unchanged. In the press conference that followed, Jerome Powell struck a more neutral tone relative to past events, refusing to commit to a pause or continuation of rate hikes in the coming meetings. Instead, Powell reiterated data dependency many times in his response to questions regarding the path of future Fed policy. On the data front, recent key releases portray a US economy that remains more resilient than many expected at this point, buoyed by low unemployment and steady consumer spending. Consequently, the ‘soft landing’ narrative was revived in financial markets as a plausible outcome for the US economy.
The implication for markets has Exhibit 1 been that the Fed may have to keep the funds rate higher for longer, an idea that has been met with much resistance this year amid prevalent recession speculation and a mini-banking crisis. Exhibit 1 tracks forward pricing in the fed funds futuresmarket relative to the most recent median Fed forecasts from the June 14 FOMC meeting. In mid-July, the bond market was pricing for roughly 150 bps of rate cuts in 2024. As we ended July, that figure shrunk to just over 110 bps. It’s worth highlighting that the median FOMC forecast also calls for rate cuts next year, on the presumption that disinflation and increased unemployment will allow the central bank to bring the policy rate down from more restrictive territory, albeit at a more moderate pace than even more recent market pricing. As for the terminal fed funds rate, we begin August with the market pricing a 40% probability of a final 25 bp rate hike this year versus the Fed’s June median forecast of a 5.625% funds rate at year-end (one more 25 bp hike).
There are a few factors to consider relative to current market pricing. Over the next 12-18 months, the current yield curve already accounts for multiple rate cuts, so for those in the ‘rates are going to fall camp,’ it’s important to understand what is already accounted for in current spot rates. If short-term rates do indeed have to remain elevated for longer than is anticipated given economic strength, then the front-end and belly of the yield curve would need to reprice for higher rates. Lastly, the market is pricing a higher long-run rate relative to the Fed, which is essentially the perceived optimal level of short-term rates that allows for economic expansion with stable inflation. This is a very difficult rate to forecast, but a higher, long-run neutral rate expectation has a greater impact on the long-end of the curve.
Data Continues to Surprise
The revived soft landing narrative has been fueled by a combination of economic factors, including below-expectations inflation in June, ongoing strength in the labor market, and an upside surprise for Q2 GDP growth. For inflation, the June CPI report showed 0.2% growth in core prices, the smallest monthly gain since early 2021, and while any downside surprises for inflation readings are welcomed, the underlying details of the report dampened optimism a bit, including large declines in typically-volatile categories like used cars and airfares. The year-over-year core rate slipped down to 4.8%, also below expectations, and the lagging effect of falling rent prices should provide further relief to the core CPI calculation in the coming months. Even so, the annual CPI measure remains well above the Fed’s target range. We’ve seen multiple downside surprises in monthly CPI growth over the last year, only to see inflation revert back and see a reacceleration of price increases in the following month, so it’s still too early to declare victory on the inflation front.
There were other positive signs of moderating inflation pressures in July, including a decline in the Employment Cost Index to 1% q/q growth in Q2 from 1.2% the prior quarter. The ECI is a preferred measure of inflation by the Fed because it tracks both wages and other compensation, including bonuses, and the Q2 growth rate was the smallest in two years. At the same time, Q2 GDP growth came in at 2.4% q/q (annualized), better than the 1.8% expected growth rate and up from 2% growth in Q1. Both of these metrics contributed to market optimism over the month.
It’s not all rosy regarding the economic outlook. The most recent Senior Loan Officer Opinion Survey (SLOOS) released by the Fed on July 31 showed continued tightening in both supply of and demand for credit in Q2, including commercial, consumer, and residential credit. This is not unexpected, but the timing and severity of the impact of tighter credit on the US economy is more difficult to forecast. The banking turmoil from earlier this year has quieted down, particularly following better-than-expected Q2 earnings releases from several small and mid-sized banks, but the industry continues to face profitability headwinds from rising cost of funds to the uncertain regulatory response to the March bank failures.
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