This week proved disappointing in that each day was jammed with economic data and a parade of Fed speakers and the market barely budged. After last week’s range-bound trading we felt certain that interest rates would break out of their recent band. The best that traders could manage was a rally in the 2-year note taking the yield-to-maturity of that issue down to 4.53%, the lowest yield in nearly three weeks.
This was a quiet week for the fixed income market, with the entire yield curve closing within a few basis points of last Friday’s close. The only real action came between late Wednesday afternoon into today’s close, as investors digested the minutes of the January FOMC meeting. As expected, the minutes echoed Chairman Powell’s post-meeting press conference comments that communicated that a rate cut was not imminent. That was enough to push the long bond up to 4.48%, the highest yield so far this year. Contributing to the rise was initial claims for unemployment insurance which totaled 201,000 for the week. That was the second lowest tally of 2024 and further evidence that the economy is not poised to enter a recession. But that wasn’t enough to offset dip-buying on Friday. On the week, the 30-year bond closed six basis-points lower, finishing at 4.37%.
In last week’s wrap we cautioned that despite the core PCE deflator touching the Fed’s target, there was a risk that the CPI wouldn’t show the same improvement. Economists had forecasted that the consumer inflation measure would rise to 3.9% year-over-year. That’s exactly where it was reported, and the month-over-month core registered 0.4%. Despite matching the forecast, traders seemingly weren’t prepared for that result because yields across the curve skyrocketed. Obviously, the report took the possibility of an early Fed rate cut off the table. Fed fund futures are now indicating that the first cut has been pushed off to this summer. The 2-year note, which had traded as low as 4.14% last month, shot up to 4.65% on the news, before closing the week half of a basis point higher at 4.655%. The inflation news also took the “wind out of the sails” of the equity market, with the S&P 500 plunging 68 points by the close of business on Tuesday. That entire move has been erased though, with the index closing roughly unchanged for the week.
As expected, with the light economic data calendar, volatility driven by data this week was nearly nonexistent. Instead of trading on economic data, traders focused on the plethora of Fed member speeches, 15 of them, with a Fed speaker hitting the tape every day this week. The message was consistent, reflecting Chairman Powell’s comments that the Fed is likely to cut rates this year, but not imminently. There was also some limited discussion about the effect seasonality could have played in the outsized January employment report. The problem with that discussion is that they don’t want to call the integrity of government reporting into question for many reasons. The primary one being if the data is flawed and they are making decision on flawed data then, inherently, the decision is flawed. As the rates market realized that the Fed might not be as early and as aggressive as it thought, yields rose with the intermediate sector of the yield curve suffering the largest increase.
The January employment report was nothing short of a shocker. The estimate was for 185,000 new jobs, and the whisper was closer to 125,000 after the Wednesday release of the ADP report showing a gain of only 107,000 jobs. Instead, the BLS reported that 353,000 new jobs were created in January and the jobs figure for December was revised up to 317,000. Collective thinking prior to Friday had been that the Fed had gone too far with their rate hikes and the U.S. was teetering on the verge of a recession. To be clear, that was not our opinion. Retailers enjoyed a strong holiday selling season, consumer confidence has bounced back, the unemployment rate is close to an all-time low, and the S&P 500 just hit an all-time high. With the employment report the expectation that the Fed will cut rates in March has been obliterated. In fact, the Fed shouldn’t be considering a rate cut anytime soon. If anything, the 4.5% year-over-year rise in average hourly income is likely to contribute further to the inflationary uptick.
Three years ago, the watchword was “transitory inflation;” that was followed last year by “higher for longer.” On the back of the Fed’s communication that they expect to cut rates three times this year, the new watch word on the street is “wait and see.” The reason for the uncertainty is the moderation the economy has displayed. Inflation has drifted lower, the jobs market remains robust, and consumers continue to consume. In short, the economy appears to be in equilibrium. Given that circumstance, the Fed should not be in a hurry to cut rates. Except that the real estate market is being negatively impacted by relatively high interest rates. The residential market is clearly being hampered by high mortgage rates, but the concurrent shortage of inventory has prevented a collapse of home prices. But commercial real estate is not enjoying the same dynamic. In addition to higher borrowing rates, commercial real estate continues to be challenged by the hangover of the COVID-related work from home mentality. While lower rates would help offset some of the expense of excess office space, we expect that the sector is in the early days of a years-long retrenchment.
At the close of trading last Friday, the street thinking was that the Fed would cut rates at the March meeting and that there would be at least three additional rate cuts this year. By Tuesday, that conclusion was being reassessed and the selling has been relentless. The 5-year Treasury is closing the week at 4.06%, up nearly 30 basis points from last Friday’s close. The initial catalyst for the move was Federal Reserve Governor Chris Waller’s comments on Tuesday morning that suggested that the Fed would be careful and deliberate in cutting rates this year which contradicted the opinion that the cuts would come soon and at every other meeting.
Communicating that they expected three 25 basis point rate cuts this year, the open market committee members convinced bond buyers that all was well and to expect inflation to continue to fall as the year progressed. Then the December inflation reports were released. On Thursday the consumer price index, year-over-year, reversed course and ticked up to 3.4%, up from the 3.1% recorded last month. The expectation was that it would rise 0.1%. On the same morning, the lesser-followed Atlanta Fed wage tracker, a measure of aggregate wages, ticked up to 5.4% year-over-year from the 5.1% recorded in November. Those measures indicate that consumers are still “paying up” to consume and are demanding higher wages to keep pace with rising prices. That result is going to make it difficult for the Fed to cut the overnight rate at the March FOMC meeting. That meeting is scheduled for March 20th, giving the Fed two more inflation reports to examine. But, given the Fed’s newfound credibility as an inflation-fighter, we think the committee will be unwilling to cut rates while inflation is still a problem.
The first week of the new year had been a quiet one until the employment report was released this morning. The headline non-farm payrolls surprised to the upside, with 216,000 new jobs added to the workforce, and the unemployment rate falling to 3.7%. At first glance the report was a solid one and the bond market immediately sold off. However, digging into the details revealed that it was not as robust as the headline suggested. Glaringly, household employment fell 683,000; the biggest drop since April 2020 when COVID crushed employment for much of the workforce. It’s not unusual for the non-farm and the household reports to deviate, but an 899,000 deviation leads us to conclude that one or the other will be significantly revised. Later this morning, the Institute for Supply Management (ISM) reported a sharp drop in their services employment survey. Again, the drop was the sharpest since April 2020. Investors seem to have interpreted the combined reports as offering a solid backdrop for the Fed’s plan to cut rates this year.
It’s been a remarkable year in the capital markets! Last December, year-over-year consumer price inflation was running 6.5% and the Federal Reserve was solidly in “higher for longer” mode with the committee prepared to continue to raise rates to quell inflation. The ten-year Treasury opened 2023 yielding 4.48%, ticked up to a high of 4.65% early in the year, before ultimately settling at 3.88%. The Fed communication has changed dramatically in the last 12 months. They dropped the higher for longer mantra this month, instead communicating that they anticipate three rate cuts in the coming year. Let’s hope they’re not premature in their abrupt policy change. By several measures, the economy continues to run hot, especially employment. It has become clear that there’s a worker shortage in the United States. The unemployment rate in November was 3.7%, just above the all-time low. The Fed usually doesn’t cut rates when unemployment is near a cycle low. But this Fed has proved that they have no interest in any rules-based policy.