With February upon us it may seem odd to revisit the December open market meeting, but the January employment report and the recent 60 Minutes interview of Chairman Powell has us wondering, “what were they thinking?” What we refer to was the dot-plot indicating three rate cuts this year. We’ve never been in favor of the Fed publicly forecasting their expected course of action and this is exactly why. After leaving the overnight rate unchanged for two consecutive meetings, bond investors assumed by their lack of action that they were probably done with the rate hikes. But rate cuts weren’t really on anyone’s radar. Speculation started to creep into the market in November as managers anticipated that we had reached the peak in rates, but the Fed’s communication caused a sharp drop in interest rates across the yield curve. That narrative unleashed a torrent of buying that sent the 5-year note from just a shade under 5% all the way down to 3.8%.
Then, Powell hedged the rate cut expectation somewhat at the January FOMC press conference with the insinuation that a rate cut would not be coming in March. In addition, he said the Fed was not entirely confident that they had beaten inflation. Two days later the BLS released the blockbuster January employment report showing that 353,000 new jobs were created during the month and that average hourly earnings had jumped 4.5% year-over-year. Digging further into the report, we found nothing that would indicate that a rate cut was imminent. Moreover, the BLS reported that the December report had been revised up to 333,000 new jobs. That’s 686,000 new jobs in two months! That can hardly be classified as a soft landing. Moreover, to cut rates into such job and wage growth would likely serve to fuel the fire of inflation.
Investors have been coming to that conclusion as the entire yield curve has moved back above 4%, with the two-year note rising to 4.43%. Despite that revaluation, fed fund futures, which had been pricing 150 basis points of cuts, is now only pricing 100 basis points of cuts by next February. That still seems like too much with the consumer price index still stubbornly high. The forecast for the January CPI, ex-food and energy, is expected to tick up to 3.9% when it’s released later this month. We appreciate that the Fed’s preferred measure of inflation is the personal consumption expenditure price index, but the public looks to CPI and as that rises it influences their perception of inflation regardless of what the Federal Reserve says.
We have read that some analysts are of the opinion that the Fed needs to cut rates now to avoid being forced to cut more sharply when growth falters. That view holds some legitimacy if the economy is showing signs of slowing. But in the current situation, where the economy appears to be showing signs of reaccelerating, that thought is a recipe for a reignition of inflation.
The recent economic reacceleration poses a problem for portfolio managers that decided to get in front of an anticipated rate cutting cycle as their portfolios are suffering mark-to-market losses. With the 5-year note retracing about a quarter of the price move since October, intermediate bond investors may want to reconsider extending duration.
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