In the wake of last Friday’s jobs report, Treasuries sold off, and yields rose, as this table shows.
Once again, there was a material difference between the ADP report, which came in weaker than expected, and the Establishment Survey, which came in stronger than forecasts.
Despite the bump in rates on Friday, one can see that rates have come down approximately 0.75% since peaking in October.
The market has been pricing in a Fed that will be cutting fairly consistently in 2024 to levels quite a bit below the Fed’s internal forecasts. Since 2022, when these disconnects have arisen in which the market priced in more Fed cuts than the Fed’s own projections, the market has lost every time. We shall see if this time is different since there does not appear to be aggressive pushback from the Fed against the market. What is clear is that absent a very surprising resurgence in inflation, the Fed is done raising rates for this cycle.
The main reason for the market pricing in Fed rate cuts in 2024 is that inflation readings are becoming more benign, and inflation expectations have been dropping.
This chart shows a model the Federal Reserve Bank of New York produced on how underlying inflation has been slowing down fairly significantly. The question is, has it stopped decelerating, or will it fall back to its pre-Covid 2% level?
Much of the huge run-up in inflation during Covid was due to supply chain disruptions. This chart from the Federal Reserve shows that this index has returned to normal.
One of the tailwinds for decelerating inflation is the price of oil, which has come down quite a bit.
This is despite Saudi Arabia making deep production cuts. The reason is that U.S. oil production has soared to pick up the slack.
Consumers benefit from lower gasoline prices, which may remain under pressure given the very large inventory build.
The 10-year break-even inflation rate has come down nearly 1% from its Covid peak when it reached approximately 3%. Inflation swap spreads have come down by approximately 0.80% since peaking in April 2022, which is when the Fed started its very aggressive interest rate hiking campaign.
Interestingly, 2-year inflation expectations are lower than 10-year expectations, suggesting a fairly significant cooling of inflation over the next two years and re-accelerating after that.
This chart shows how shorter-term inflation pricing has dropped fairly dramatically in just the past week prior to Friday’s employment report (December 8, 2023).
Although the labor market is slowing, albeit still healthy, unit labor costs dropped in the third quarter due to improving productivity. This is another data point giving investors confidence that the worst of inflation is behind us and that there is a high likelihood that it was transitory after all.
It appears that leverage is shifting back to employers as quit rates are dropping fairly significantly.
And while job openings are still high, they have been decelerating, although this data is subject to large revisions. I have written about this before, but I believe this is due to the construction sector still going strong, despite much higher rates, because of significant federal spending for infrastructure and green initiatives.
The number of jobs available relative to the number of people unemployed is still at an elevated level, although it has dropped quite a bit from its Covid highs. I think the Fed would like to continue seeing this drop materially before it contemplates cutting rates.
The ISM Manufacturing Purchasing Managers Index has dropped for 13 months in a row, which is consistent with past recessions.
One looming economic risk is that many companies are far weaker financially and at greater risk of defaulting on their debt and filing for bankruptcy. Financial distress can lead to layoffs and reduced economic activity.
Perhaps the market is pricing in greater financial pressure coming to bear after such aggressive monetary tightening and rate increases. It’s not necessarily showing up in the data as the labor market is holding up, fiscal spending is propping up construction, and many homeowners have locked in long-term, low-interest-rate mortgages. When it comes time to refinance or interest rate caps have to be purchased or repurchased; however, firms may not be able to come up with the cash to fully repay their loans or pay for the much more expensive caps. This could lead to defaults and properties and businesses being lost.
On the other hand, maybe the market is less concerned about financial distress and believes that real interest rates are too high, and the best policy decision the Fed can make to avoid a recession is to cut rates sooner rather than later. This will help loosen the frozen home market, take some pressure off banks sitting on underwater mortgages, and lessen the potential financial distress related to a large number of maturing loans in 2024 and 2025.
This chart shows the history of one-year inflation-adjusted interest rates. The average since 1983 has been 1.41%. With inflation decelerating, the Fed can cut rates by approximately 1.50% and still have room to bring them down more if the economy contracts meaningfully or raise them again if inflation re-accelerates.
The first quarter should be interesting to see if the Fed finally moves.
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