August begins with the market once again pricing for more dovish Fed policy relative to their guidance
The July 31 FOMC meeting was ‘cautiously dovish’ and opened the door for a potential rate cut at the September meeting
We look at the recent economic data as a whole and discuss the market reaction
We begin August with the bond market once again priced on the more dovish end of the spectrum relative to Fed guidance. More economic reports released in July suggest further moderation in labor market and inflation metrics, and fed funds futures are now pricing for 75 basis points (bps) of rate cuts over the final three FOMC meetings of 2024. Treasury yields in the 2- to 5-year part of the curve fell approximately 50 bps over the month of July, which corresponded with short-term rates markets pricing for a similar amount of additional rate cuts by April of next year (~125 bps in total).
There was much anticipation ahead of the July 31 FOMC meeting. While there was some fringe speculation that a rate cut might be announced at that meeting, the general expectation was that the Fed would open the door for an initial cut in September. Powell & Co. did indeed open the door, but it was certainly not a commitment to a particular action. Instead, the official statement shifted to a more balanced assessment of upside/downside risks to its dual mandate (price stability and full employment), and Powell remained adamant that any such decision will be dependent upon the totality of new economic data in the coming weeks. If we were to characterize the tone, perhaps ‘cautiously dovish’ would be appropriate.
Recent Data Trend
With Fed leaders adamant about a meeting-to-meeting, data-dependency approach to future policy decisions, it’s worth reviewing a sampling of data releases over the last month that has garnered the biggest market reactions. Exhibit 1 tracks several data points relative to expectations leading up to each release as well as the prior period’s reading. Most of the data points would suggest moderation in the underlying trend as opposed to sharp declines, and there are some upside surprises on the consumption side (retail sales, personal spending, etc.). This is likely why Powell is urging a more cautious tone.
Exhibit 1
Most recently, there was a relatively strong market reaction to the ISM manufacturing survey on August 1, which showed a 2-point lower reading relative to expectations (readings below 50 imply contraction in activity). Was this due to a notable decrease in demand for factory-produced products, or are some companies being more conservative in capital outlays in anticipation of Fed rate cuts in the near future? The truth likely lies in the middle. The report suggested as much, saying, “demand remains subdued to current federal monetary policy and other conditions.” Of course, it’s also important to note that the U.S. economy is far more dependent on the services sector than manufacturing, but nevertheless, financial markets are clinging to any signs of a sharper slowdown in overall economic activity and, consequently, more dovish Fed policy.
It’s also worth revisiting comments made by Atlanta Fed President Raphael Bostic in March, where he expressed some concern about the idea of “expectant optimism” on the part of business leaders he had met with in prior weeks. Essentially, these leaders suggested that activity was moderating, but not at distressed levels, and regarding capital investments, they said they were generally on pause and ready to pounce on the first hint of a Fed rate cut. This is a bit anecdotal, but it is likely still lingering in the minds of policymakers in determining next steps.
Whether reviewing the last month of data or the last 6 months, there does appear to be gradual cooling in the labor market and overall inflation growth. Is it enough to cause alarm for policymakers to move swiftly on policy easing? It wouldn’t appear so to this point, but there are several pockets of financial markets very eager for that to happen and for good reason (e.g., commercial real estate loan refinance risk over the next 12 months). If we see upside surprises in the next inflation and employment reports, the Fed may be more inclined to sit tight at the September FOMC meeting, but we wouldn’t focus so much on these more myopic considerations. Barring a major surprise, the Fed will very likely initiate policy easing before the end of the year, and it’s really more about how much the economy does actually slow over the next year as it drives the ultimate terminal fed funds rate, asset spreads, and interest rate volatility. Regarding the latter two, there are several external factors that could have a say, including the November election results, the U.S. fiscal outlook, and global geopolitical tensions. These are all very difficult, if not impossible, to predict, so financial institutions would do best to continue focusing on disciplined risk management, including risk-adjusted asset pricing, sound capital utilization, and hedging interest-rate risk as needed. This recipe for high performing institutions is independent of any particular market environment, and success relies on good discipline in execution.
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