Recent data and comments from members of the Federal Open Market Committee (FOMC) suggest that the Federal Reserve might opt for a precautionary interest rate cut in September, even though the U.S. economy remains robust. This type of cut, often termed an "insurance" cut, is intended to preemptively address potential economic slowdowns or emerging risks, rather than respond to an existing recession. The aim is to support continued economic growth by encouraging borrowing, investment, and spending, thereby steering the economy towards a smooth transition.
While such a measure could be beneficial for the stock market, its impact on the bond market could be more nuanced. Typically, a combination of declining inflation and lower interest rates results in higher sovereign bond prices. However, this time around, investors might need to be more discerning in their selection of bond maturities. There is a possibility that economic acceleration could impact long-term yields, complicating the outlook for bonds.
A crucial factor to consider is the potential increase in the long-term equilibrium Fed Funds rate, even as short-term rates are cut. This would set a "floor" for the longer end of the yield curve, meaning that long-term bond yields might not decrease as much as some investors anticipate. The rationale behind this is the current strength of the economy, which may be operating at a higher equilibrium level than in previous years.
From June 2019 until March of this year, the long-term neutral Fed Funds rate held steady at 2.5%, before rising to its current level of 2.75%. If the Fed were to lower rates to this level in the coming years, the 10-year U.S. Treasury yield might stabilize at a margin of 100-150 basis points above the Fed Funds rate as the yield curve normalizes. This would imply a fair value for the 10-year Treasury yield between 3.75% and 4.25%. Should the neutral rate continue to rise, the fair value for the 10-year Treasury would adjust upwards accordingly.
This scenario indicates that while the short end of the yield curve might drop due to expectations of monetary policy shifts, the long end could rise significantly, leading to what is known as a bear steepening of the yield curve. This occurs when long-term bond yields increase faster than short-term yields, causing the curve to steepen. In such a case, we might see short-term yields decline as the Fed reduces rates, while long-term yields climb as the market demands a higher risk premium for holding longer-term bonds. This shift is generally seen as negative by the markets, as a significant portion of the economy’s debt is linked to long-term interest rates.
The broader economic landscape suggests that a recession is not imminent. After a week of market speculation about a potential recession, fresh U.S. economic data released on Thursday contradicted this view. Retail sales, excluding food, rose by 2.6% over the past year, and recent declines in continuing jobless claims indicate that consumers are still spending and the job market remains resilient, despite a slight increase in the unemployment rate in July.
Consumer spending remains strong, as evidenced by growth in ten out of thirteen retail categories, with only clothing, miscellaneous store retailers, and sporting and hobby goods showing declines. This trend is reinforced by the University of Michigan Consumer Sentiment Survey, which has shown rising consumer confidence since June 2022. Although there are signs of economic uncertainty, such as more selective spending behaviors reported by Walmart and a cooling of post-pandemic travel, it is clear that a recession is not on the immediate horizon.
Inflation remains a pressing issue, with the latest NFIB survey revealing that it is the top concern for 26% of small businesses. Additionally, 24% of these businesses plan to raise prices in the next three months, signaling ongoing inflationary pressures. The St. Louis Fed’s Price Pressures Measure indicates a 97% probability that inflation will exceed 2.5% over the next year.
Despite a rising unemployment rate, a recession still seems unlikely. The current unemployment rate of 4.3% is slightly higher than recent historical lows but remains below the long-term average of 5%. The increase is primarily among reentrants and those on temporary layoffs, rather than permanent job losses. This stability in permanent job losses suggests that the labor market remains strong. Moreover, wages are growing at a rate of 3.6%, above the historical average, which supports consumer spending and overall economic stability.
Given these conditions, the expectation of significant interest rate cuts by year-end appears overly optimistic. Persistent inflation and strong economic activity suggest that the Federal Reserve may not be able to deliver the expected cuts. Consequently, markets have adjusted their expectations, reducing the likelihood of a 40 basis point rate cut in September to 33 basis points, and lowering the probability of four rate cuts by the end of the year.
FOMC members' statements following the July meeting indicate a potential rate cut in September. Key voting members, including Bostic, Bowman, Daly, and Powell, have expressed a willingness to consider such a move.
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