August 2024
September started off with a bang in terms of corporate new issuance with the four-day issuance totaling approximately $85 billion. The Treasury buying continued as well, with the entire yield curve, save the unloved 20-year note, all trading below 4.00%.
The catalyst for the buying initially was the August employment report. The report, which could be described as mildly disappointing, showed 142,000 new jobs were added in August, below the 165,000 expected. But what caught traders’ eyes was the previous month’s revision to 89,000. The report was enough to cause some economists to revise their forecast for the coming rate cut to 50 basis points. That speculation turned into consensus by the morning of the report when Federal Reserve Governor Chris Waller, in a speech at the University of Notre Dame, explicitly said that the plan is for a larger than expected rate cut. We take that to mean 50 basis points later this month.
The final hurdle for a 50-basis point cut was the inflation report. The CPI continues to register at an elevated level, but as Charman Powell communicated at the Jackson Hole summit last month, employment has become the greater concern. With that in mind August inflation measures are unlikely to dissuade the Fed from cutting rates. The August report was a mixed bag, with month-over-month core inflation rising 0.3% versus 0.2% expectation, while year-over-year headline was 2.5% and core was 3.2%, both in line with expectations. Not great, but not enough to criticize the Fed for cutting 50 basis points should they decide to do so.
With the stage set for the Fed to enter the rate cutting cycle we’re hesitant to buy into the aggressive rate cut expectations. The Fed Fund futures market, which is an excellent proxy for trader expectations, is trading at 2.85% 13 months from now, that’s nearly 2.50% lower than the current Fed Funds rate. That’s aggressive given that while employment has clearly slowed, it continues to expand which likely means that growth is slowing but not contracting. In fact, the GDPNOW forecasting tool published by the Atlanta Federal Reserve, is registering 2.47% growth in the third quarter. Moreover, when the Fed lowers the overnight rate, it’s easing monetary policy which typically accelerates economic growth. Cutting rates by 2.5% over the course of 12 months while inflation is still above their target will likely reignite inflation, forcing the Fed to repeat the entire process again.
The wild card, of course, is the next President. Both sides have espoused policies aimed at accelerating economic growth and neither is averse to deficit spending, which is already arguably out of control. That probability is already being reflected in the yield curve. The spread between the 2-year note and the 30-year bond was inverted by 35 basis points as recently as late June. Since then, it’s gone positive and currently is 37 basis points. The reason why yield curves are typically positive, under normal circumstances, is that longer term investors want to be compensated for long term inflation risk. If the Fed cuts rates by 2.50% in the coming year, that spread will be a lot more than 36 basis points, which may keep mortgage rates relatively high.
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