Markets Levitate on Dovish Pivot Hopes
U.S. long-term rates fell last week prompting equity markets to surge from multi-month lows after the Federal Reserve kept rates steady and signs emerged of slowing U.S. wage growth. Ten-year U.S. Treasury yields had the largest weekly drop in a year and are now roughly 0.50% below the 16-year high hit just two weeks ago. The magnitude and velocity of these moves highlight the tenuous positioning of markets as participants attempt to handicap whether we’ve seen the peak in Fed policy rates.
The U.S. labor market finally showed signs of slowing with nonfarm payrolls increasing by 150,000 jobs last month, falling short of the consensus forecast of 180,000. A cooling U.S. job market provides the Fed the flexibility to keep interest rates on hold next month and reinforces market views that the central bank is done with rate hikes. Next week’s CPI report will be a critical factor in further shaping market expectations of a dovish pivot (i.e. rate cuts) from the Fed. Assets that have rallied on the premise that the Fed will start cutting rates sooner than expected next year risk getting disappointed as inflation is still running well above target. Core inflation is expected to rise 0.30%, and core PCE, the Fed’s preferred measure, at 3.7% remains well above the 2% target. Potentially more troublesome is that near-term consumer inflation expectations have recently ticked up, further complicating the Fed’s stance.
The market narrative of just over a week ago was that Treasury supply would overwhelm demand to fund exploding deficits, while some of the largest structural buyers (the Fed, China, Japan) were stepping away. This plot quickly unwound as markets now seem confident that rates have peaked. Expectations of a Fed pivot however can become self-defeating, since rising asset prices boost consumer confidence and act to ease the financial conditions that central banks have desperately tried to tighten in order to bring down inflation. Tighter financial conditions are a function of lower risk assets, a reduction in liquidity, and a strong U.S. dollar to name a few. The Fed needs tighter financial conditions to slow economic demand and increase unemployment, thereby lowering inflation toward target levels, but they don’t want an economic event destabilizing the financial system.
Comments from U.S. central bankers this week have emphasized the need for vigilance around inflation with Chicago Fed Bank President Austan Goolsbee saying that policy makers don’t want to “pre-commit” to decisions on rates. Fed Chair Powell is set to deliver comments tomorrow at an IMF conference, and markets will be eager to see how hard he pushes back against the recent drop in bond yields.
Despite rising yields year-to-date, the equity market has been surprisingly resilient. The market seemingly pricing in a scenario of a soft landing, low rates, rising asset prices, and low inflation may be overly optimistic. While long-term interest rates climbing is good news for the Fed on the inflation-fighting front, it also stresses the balance sheets of many large institutions holding long-term fixed rate bonds at large unrealized losses. This raises concerns about financial stability and further complicates the Fed’s policy path. With government interest payments set to eclipse $1T, the current fiscal situation is unsustainable. As we approach an election year, the Fed will come under increasing political pressure to lower rates regardless of the broader macro backdrop.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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