Market Overreaction or Necessary Adjustment? What’s Next for the Fed?

Market Overreaction or Necessary Adjustment? What’s Next for the Fed?

Over the last couple of weeks, we’ve witnessed a significant repricing in the front end of the USD rates curve. While there are arguments both supporting the necessity of this shift and suggesting the market might have overreacted, today we’ll delve into the data and commentary driving this movement. We’ll also explore potential risks in the coming period and how these may influence other macro structures beyond short term rates.

Inflation Defeated?

At the start of July, markets were pricing in approximately 50bps of cuts from the Fed for the remainder of 2024. The first signs of a market reprice came on 11^th July as CPI figures were released. While we expected some improvement, the result exceeded our expectations. Headline CPI fell to 3% from 3.3%. Core CPI also came in lower than anticipated at 3.3%. Although this may only have been an undershoot of 0.1%, it was sufficient for the markets to add an additional 17bps of cuts into the curve. In hindsight, this excessive repricing in the face of minimal undershooting was a warning sign of things to come. These July figures were in some way, confirmed by the releases in August, with headline CPI again coming in lower at 2.9%, and core figures fell by another 0.1% to 3.2%.

While this was good news, almost an additional full 25bps cut felt excessive to us – and the rhetoric from Fed speakers agreed. Jeffrey Schmid called the decline in inflation “encouraging” but noted that “we are still not quite there,” indicating he would like more data points to gain sufficient confidence before starting a cutting cycle in earnest. Fed Chair Jerome Powell had a similar view, “the job is not done on inflation but nonetheless we can afford to begin to dial back the restriction in our policy rate.” In other words, we’re ready to begin adjusting but let’s not get excited.

Labour Market Instability

Market participants seemed to miss the “don’t get excited” memo. Following labour market data released at the start of August, the curve repriced to add some 120bps of cuts in 2024 – from 50bps just a month earlier. So, what happened?

Fears of a softer US labour market were initiated by a weaker than expected July Non-Farm Payrolls report (+114k vs +175k expected) and a -27k downward revision for June. This was coupled with the highest unemployment rate (4.3% vs 4.1% expected) since October 2021. Then, the Bureau of Labor Statistics released its benchmark revision, revealing that in the year leading up to March 2024, the US had in fact added 818k fewer jobs than previously thought.

Adding to the concern, we are now at risk of breaching the Sahm rule, which suggests a recession is imminent when the rolling 3-month average unemployment rate is 0.5% or more above the 12-month low. We are right on the cusp of this limit.

Growth Persists Amid Concerns

While recent trends in the labour market are somewhat concerning, they should be viewed in a broader context. Although unemployment rates are rising, they remain less than 1% above lows since 2000 and before. And, yes, the US added fewer jobs per month over the year to March than initially thought, but the economy still added on average 174,000 jobs per month – that’s a healthy pace. Add to this the continued strong GDP growth – we continue to see the US post growth numbers in and around 3% - far from a cause for concern.

Jackson Hole

With this backdrop in place, all eyes were on Powell’s address at the Jack Hole conference. Markets had anticipated a bearish speech and, in their eyes, he didn’t disappoint. The “time has come” for the Fed to lower rates, Powell told us, and that the “direction of travel is clear.” The market took this as affirmation of the cutting cycle priced in, but he added, “the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the balance of risks.”  So, what did we really learn? We know that cuts are on the horizon, and it is indeed time to begin normalizing the level of rates, but little from the speech struck us as clear indication that 50bps cuts and an aggressive cutting cycle is imminent.

Market Outlook

At time of writing, markets are expecting 100bps of cuts in the remainder of 2024 and a further 125bps through 2025. This necessitates at least one 50bps cut in the remaining three meetings this year and more than a 25bps cut per quarter in 2025 – notably more aggressive than the UK or Europe. Barring a serious downturn, this feels like a maximal rate progression, and we see the clear risk being an under delivery from the Fed. This creates a number of opportunities for hedges of floating rate liabilities – in the simplest sense, a fixed rate swap looks increasingly attractive. The steeply downward sloping curve means that SOFR payers can immediately reduce their interest expense by swapping to fixed, a 3-year mid-market fixed rate is currently around 3.5% with 3-month term SOFR sitting at over 5%. For those seeking more flexibility, caps and floors may be worth considering. The aggressive moves have helped keep skew (the comparative pricing of caps vs. floors) in the hedgers favour. Under current market conditions, a hedger can buy a 3-year cap with a strike of 4% and sell a floor with a strike of 3%, guaranteeing their interest payments come in at least 100bps below the spot SOFR – and get paid to implement the structure.

Market volatility looks set to continue and the time is ripe to remove macro risk from portfolios that are not focused on such markets. The next key data point is the US labour market data released on 6^th September. After this, the Fed enters a blackout period ahead of their next meeting – news that is unlikely to ease tension in already nervous markets.