AFMC - Why The Jobs Market May Be Key To The Fed's Future Rate Strategy

2023-06-20 09:30:00 ET

Summary

• The data has been coming in strong enough that the Fed could have delivered a rate hike in Wednesday’s meeting, but they chose not to.
• In the last couple of weeks, jobless claims have not just been higher than expected claims, but we're seeing a trend where the average of the last several weeks is very clearly in an upward trend.
• How that continues from here on out, and before the next meeting, might give the Fed indication of whether the job market is starting to exhibit better balance and will be the key in determining whether it delivers more rate hikes.

Originally Posted on June 16, 2023

Even as it pauses its tightening cycle, the U.S. Federal Reserve is signaling two more rate hikes may be on the way. Alexandra Gorewicz, Portfolio Manager at TD Asset Management, explains why the Fed may be focusing on the employment sector when determining its next move.

Transcript

Greg Bonnell: US Federal Reserve held its key interest rate steady after 10 consecutive hikes. But some market watchers are calling it a hawkish skip. Of course, the Fed did signal that there could be more hikes ahead. Joining us now to discuss how this sets up the bond market for the second half of this year is Alex Gorewicz, Portfolio Manager for Active Fixed Income at TD Asset Management. Alex, always good to have you on the show.

Alexandra Gorewicz: Thanks, Greg. Great to be here.

Greg Bonnell: All right, so whatever you want to call it-- a pause, a hawkish skip. We know that the Fed, although they did not take any action yesterday, they did give us an indication that they think they have further to go. Let's start there, how do we read that from the world's, arguably, most powerful central bank?

Alexandra Gorewicz: It was-- this is probably the first time I'll give Powell credit for all the experience he has in terms of being able to communicate an otherwise a bit of a head-scratcher decision as far as investors and market pundits go. He was able to communicate the rationale in a pretty concise and convicted manner. But it doesn't change the fact that the data has been coming in strong enough that the Fed, which is communicating it probably will deliver another two rate hikes before the end of the year, could have done it yesterday. And they chose not to.

Greg Bonnell: Yeah, it's one of those things like, all right, we're going on a road trip, we got to cover a lot of ground, and so let's go. I say, well, not yet. There was a bit of confusion-- then just why not go for it?

But I think he was sort of giving themselves a little bit of time, maybe a breather to say, we've done a lot in this short period of time. Let's see what the effects are. What do we got, about five, six weeks till the next meeting? Could things actually turn in the data that would actually cause them to rethink their stance?

Alexandra Gorewicz: Look, anything is possible. And in fact, if we look at jobless claims in the last couple of weeks, we have seen not just higher than expected claims, but we're seeing now a trend where the average of the last several weeks is very clearly in an upward trend. How that continues or how that evolves from here on out, and certainly before the next meeting, might give the Fed indication of whether the job market is starting to exhibit better balance.

And I think that, more than anything else, is ultimately the key for the Fed in determining whether they're going to deliver more rate hikes. And I don't think it's lost on any of us that that seemed to come up time and again from Powell in answers to questions about what they're looking for to determine whether to hike rates further.

Greg Bonnell: Of course, one point-- Chair Powell did get that question about, when are you going to start cutting? Because there's been a push and pull between what central banks have been telling us during this rate hiking cycle and what the markets have been telling us in terms of what they thought you would get in terms of reversal. And at one point, it wasn't even that long ago, maybe even the last time you were on, we were talking about the potential for cuts in the summer or the fall just based on market pricing.

That has disappeared. Jerome Powell was pretty adamant. He talked in terms of years. He said this is a place we need to get to and a fight we need to sustain for years. So again, a pretty strong signal to the market-- do we take that at face value?

Alexandra Gorewicz: So--

Greg Bonnell: Years is a long time.

Alexandra Gorewicz: Well, yeah, but I actually find that a little bit misleading. And the one thing that I would have liked to have seen reporters ask him about or challenge him about was why the median dot for 2024 is 100 basis points lower than the median dot for 2023.

Greg Bonnell: Yeah, because then that would mean you're not going to get there without cuts.

Alexandra Gorewicz: Correct. Correct. And that, to me, is probably the most important question to ask, because that difference-- 100 basis points of rate cuts or even some rate cuts has consistently been communicated by the Fed between '23 and '24, even as far back as the end of last year's dot plot. But the most recent update continues to show that rate cut, despite the fact that they think, well, at some point this year, we still have more rate hikes to deliver.

And then if you think about the magnitude, let's say 100 basis points as the difference between the two median dots, and that's supposed to be to the end of 2024, well, they're not going to deliver 100 basis points all in one meeting, let's say, in December of next year. So that will very likely start in a more gradual fashion, as far as the Fed's concerned, probably within the next 12 months.

So here, you see why it's a head-scratcher for investors who say, well, over the next couple of months, you still have to deliver two more rate hikes. But then over the next 12 months, you start cutting? And if the Fed-- and Powell did acknowledge that they don't really have a lot of visibility out beyond a couple of months, which I understand. I appreciate how uncertain the environment is. But if that's the case, why are you already communicating rate cuts for next year?

Greg Bonnell: What does it mean for fixed income, maybe in the second half of this year? Startlingly so, but you look at the calendar, we're almost halfway through this year.

Alexandra Gorewicz: Correct. So what does it mean? It means that despite the volatility that we've seen in interest rates this year, we've done a number of round-trips where to start the year, interest rates came down 60 to 70 basis points, then they came back up through February, then they came back down through March and back again. We've literally done round-trips in the matter of weeks of 60 to 70 basis points.

That's not insignificant in a very short period of time. And I think that could persist. But what that also tells you is that what you're really doing is you're clipping your coupon, right? You're getting income. And although interest rates right now are higher than where they were at the start of the year because of all of these round-trips, total returns on bonds are still positive, which, again, is a sign that income is helping to offset some of these negative price impacts.

Greg Bonnell: At the heart of all this, Alex, of course, is inflation, right? There was a time where it was going to be transitory. It wasn't transitory. The central banks got aggressive. Here we are today in the situation that we're in. Are you seeing signs that, indeed, they're winning this battle?

Headline seems pretty decisive. Watch your headline graph, and it goes up high from here, and it goes down low to here. But underneath that, there seems to be concern.

Alexandra Gorewicz: Yeah. So Powell broke it down into, effectively, three categories. He talked about inflation that came from the goods sector. And there, he said that there's been a lot of moderation in, let's say, global supply chains and all kinds of supply-related pressures that are helping to bring those prices down relatively quickly. And we're seeing that as well.

Then he talked about housing. Housing is probably the one sector component that responds most clearly to monetary policy tightening or easing. However, the lags are quite substantial. So in other words, it could take anywhere between a year to 18 months to actually start seeing the effects of tightening. And we've seen some correction in US housing. Perhaps, we'll see more as the Fed continues to deliver rate hikes, albeit at a slower pace. But they know that it's having an impact-- their monetary policy tightening is having an impact in that sector, and they expect housing to continue to moderate.

Then, he mentioned services. And on services ex-housing-- on services, he did talk about how that was the most labor-sensitive segment, effectively, of the inflation basket. And what he really did was to tie the fact that at this point, to bring inflation down in the US, you need to start seeing cracks in the labor market.

And he didn't talk about cracks, obviously, but he did say that there needs to be a better balance or you need to see a moderation in wage growth. And what that really means is they're looking for an uptick in unemployment. And if you look at the projections that they put out alongside the decision, their updated projections, they've actually decreased the rise in unemployment rate that they're expecting for this year.

Previously, they were expecting the unemployment rate to rise to about 4.5% to the end of the year. Now, it's only about 4.1%. So in many ways, although they're communicating that they have to raise rates further, they actually think it's going to be an even softer landing than they thought before.

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