Updates

What will move the Fed out of its current wait and see stance?

• Earlier today, the U.S.’s Bureau of Labor Statistics released hotter than expected CPI data – confirming investors’ anxiety regarding too-hot inflation that is likely to keep the Fed on the sidelines for the immediate future. January’s consumer price index jumped 0.5% for the month, putting the annual inflation rate at 3%. Both were more than the 0.3% and 2.9% increases expected by economists polled by Dow Jones. Excluding volatile food and energy prices, the core CPI rose 0.4% on the month and 3.3% for the past 12 months, again both higher than expected.

• Meanwhile, the Labor Department’s last Friday jobs data was more encouraging as the unemployment rate beat expectations and declined to 4.0% last month. Experts expected the economy to add 169,000 jobs in January although only 143,000 positions were added; this represented a drop in jobs creation even relative to the November and December data. However, the year-end 2024 job market was much stronger than previously thought. Jobs estimates for November and December were revised upwards a total of 100,000 positions.

• How does the strong job’s data impact the Fed? The January jobs report is unlikely to cause Powell and other senior Fed officials to alter their current wait-and-see approach to interest rate cuts. The U.S. central bank remains focused on ensuring inflation continues to its gradual decline toward its 2.0% target. To date, it has expressed little concern that the labor market is driving inflationary pressures nor that it is foreshadowing recession – certainly, a goldilocks moment. However, today’s inflation report combined with the “just right” jobs data almost guarantees the Fed will hold off of any near-term moves.

• Current predictions show only a 30% likelihood of a rate increase by mid-June. However, some large unknowns such as U.S. tariff policies could quickly change current expectations. Of particular concern to inflation hawks, President Trump announced his intention to place 25% tariffs on imports of steel and aluminum to the U.S., levying this fee even on the U.S.’s closest of allies such as Canada, Mexico, Japan, and South Korea. This position is more extreme that the tariff posture taken during the first Trump Administration where businesses could file for exclusions from a given tariff. If actually implemented, these taxes on imports to the U.S. could cause appreciable inflation in America – exactly what the Federal Reserve has spent the last 2+ years fighting against.

Fed stands pat to no one’s surprise….

• Fed Chair Powell held his first press conference of 2025 today. To the surprise of no one, the central bank took no action on interest rates. However, what was more important about today’s announcement was the commentary. Powell’s disposition and language favored neither a dovish nor hawkish position. According to the Fed Chair, although hiring has slowed, the labor market remains in a good position as is also the economy. Inflation is yet to achieve the target of 2%, but it continues to make progress. Powell emphasized that the Fed would continue to be data dependent and not let outside parties, i.e., implying the White House, pressure the committee on future rate decisions.

• President Trump returned to the White House last week and once again smartphones are actively buzzing with new breaking news. One of the Administration’s most significant proposals is a sharp increase on many imported goods. If enacted, this move would almost certainly help reignite inflation – the very thing that the U.S.’s central bank has spent the last two years trying to tame. However, so far 2025 is off to a good start with December inflation figures beating expectations as the readings came lower than originally forecasted. However, inflation data is a lagging economic measure. As a result, any inflationary effects from actions of the new Trump Administration are unlikely to be seen before this summer, at the earliest.

• Looking to the financial markets, the recent release of China’s DeepSeek AI caused sharp declines in all AI and AI related stocks on Monday. To the dismay of semiconductor companies like Nvidia, Broadcom, and others, the Chinse AI firm claims that its product operates at a fraction of the cost of its rivals. If these claims prove true, there could be sharply lower demand for advanced chips and the many products and services associated with the nascent AI industry.

• Of concern for stock investors, the equity risk premium recently turned negative. Defined as the difference between the corporate earnings yield and the yield of the 10-year Treasury, the differential between the two figures indicates how much investors are compensated for the greater risk of owning stocks over risk-free government bonds. Given their risk profiles, over the long-term stocks should provide a higher return than risk-free bonds. In recent days, however, there has been no additional premium to hold stocks over bonds – a concerning assessment regarding the valuation of the current stock market. As a result, Wall Street is lacking critical support for meaningful sustained additional advances. However, as we have discussed previously, the “animal spirits” can drive markets upwards for quite a while although underlying fundamentals can be weak.

2024 Year Wrap Up…

•U.S. equity markets recorded another banner year and proved their resiliency once again.  Led by the Magnificent 7 tech stocks, the S&P 500 finished the year with a 25% gain as the Russell 1000 Value advanced a robust 14%. The Russell 2000, which focuses on small cap companies and is considered a more accurate barometer for the local economy, finished the year with a 10% gain.  Ten of the eleven equity sectors finished positive, with the majority having double digit returns.

•In looking overseas, European equity markets performance was largely a mixed bag. The Germany markets led the way with a 19% gain while France’s CAC 40 was a substantial laggard with a 2% loss, largely on the back of ongoing political turmoil and fiscal deficit issues. Looking further east, Asian markets had strong performances, all finished the year up double digits, led by Japanese market’s 20% gain on the year.

•Reviewing rates, the Fed’s overnight lending rate finished the year in a range of 4.25-4.50% thanks to three rate cuts in the latter part of the year. The U.S. Treasury 10-year rate finished the year at a relatively elevated level of 4.53%, substantially higher than the sub 4% rate found at the beginning of the year. Throughout 2024, the Treasury yield curve largely flattened – going from being an inverted yield to a more traditional rising curve, albeit remaining fairly flat. One area of the fixed income asset class that struggled was long dated bonds which felt the biggest effects of a rising 10-year Treasury yield.

•Looking at commodities, they had quite the roller coaster of a year across the asset class. Gold and silver had a banner year, finishing at all-time highs, largely fueled by speculation and their appeal as asset safe havens. Oil struggled last year, with Brent and WTI finishing the year negative. But, while oil struggled, natural gas finally finished the year with a 50% gain. Overall, an interesting year, to say the least!

After today’s rate cut, is the Fed ready to pause?

• Chair Powell and the FOMC had their final meeting of the year today and announced a 0.25 percentage point cut to the overnight borrowing rate. In addition to the rate announcement, Chair Powell provided guidance to the Fed’s interest rate path moving forward. He stated that the Fed now expects two rate cuts in the next year which was an appreciable downward adjustment from prior expectations of four potential cuts. The markets were not receptive of this news and sold off.

• It is largely believed that the Fed made the additional cut because of the cooling labor market – while layoffs are not increasing, neither is hiring. The unemployment rate began the year at 3.7% and has slowly increased over the year to 4.2%. The rate cut comes despite the prolonged battle against inflation, and growing fears that Trump policies could be inflationary. Last week, the most popular inflation readings, CPI and PPI, released their monthly figures for November. The Consumer Price Index (CPI) largely met expectations, but the core CPI figure continues to hover above the 3% mark. The Producers Price Index (PPI) posted a 3% annual increase, the largest annual increase since February 2023. With several inflation readings remaining appreciably above the Fed’s target of 2%, the argument for continued appreciable rate cuts is becoming more tenuous.

• A number of important economic releases occur this week and they will have a significant impact as we enter 2025. Manufacturing data released on Monday signaled that U.S. factories are experiencing their highest level of activity in nearly three years. Tuesday, U.S. Retail had a month over month gain that beat expectations and showed the resiliency of the U.S. consumer. Today, Wednesday, housing data released was a mixed bag with a decline in housing starts but a significant increase in single family housing starts and building permits. On Thursday, additional housing data will be released along with jobless claims. Finally on Friday, to cap off the week, the Fed’s preferred inflation gauge, the personal consumption expenditure (PCE) figure will be released. Expectations are that it will indicate a 2.8% annual increase in prices for November, an appreciable increase over October’s annual reading of 2.3%.

Higher for longer after all…

• Equity markets participants showed their approval of the re-election of President Trump as the markets surged to record highs in the following days.  Further adding to market sentiment was Fed Chair Powell’s announcement of a quarter percentage point cut to the overnight lending rate. Some of the initial post-election market enthusiasm faded as global geopolitical risks escalated. International tensions escalated following the U.S. authorization for the Ukraine to attack Russian territory of Ukraine’s with American supplied long-range missiles. Somewhat counterintuitively, long-term interest rates have surged in recent days to 6-month highs on growing fears that Trump Administration policies could reignite inflationary pressures.

• The Fed’s chair stated that “the economy is not sending any signals that we need to be in a hurry to lower rates. The strength we are currently seeing in the economy gives us the ability to approach our decisions carefully.”  On the back of these announcements, experts reduced the likelihood of a December rate cut to 60% from prior expectations of an 80% likelihood. Additionally, traders have reduced expectations of rate cuts by 1 percentage point with forecasts now anticipating overnight rates of 3.9% by year-end 2026 rather than prior forecasts of 2.9%

• On the inflation front, last week’s Consumer Price Index (CPI) and Producers Price Index (PPI) data were released with both figures meeting expectations. The CPI showed an annual increase of 3.3% with more than half of the gain being attributed to housing costs. The PPI print came in at 2.4% – a stark increase from the previous month of 1.9%. Both figures, echoing Chair Powell’s commentary, indicated that there are some inflationary components that remain elevated and may be taking longer than previously anticipated to decline to more acceptable levels.

Presidential Election & Federal Reserve meeting have market anxious…

• The Presidential election is finally here, and the race remains a dead heat with pollsters saying the race is a coin toss. Given how close the race is, a winner is not anticipated to be known for days. However, investors have been trying to position their portfolios based upon their expected winner. With the race being so close, this is likely a fool’s errand.
• The leaders of the US central bank are set to meet this week, their second to last meeting for the year. Currently, the market is predicting a near certainty, a 98% chance, for a quarter percentage point rate cut thus reducing overnight interest rates to a range of 4.50%-4.75% from its current range of 4.75%-5.00%. Overall, economic activity remains promising.

• The latest GDP readings had the economy has growing by a 2.8% annualized rate of growth over the last quarter. Inflation has continued to decline with the latest PCE reading in September of 2.1%, almost achieving the Fed’s 2% goal. On the downside, employment reports for August and September were revised lower, and payroll growth in October is expected to be much weaker, emphasizing that wage growth is cooling. A primary contributor to the negative payroll/jobs data has been the ongoing Boeing strike which was just resolved this morning.

• Meanwhile, equity markets continue their ascent on the back of modest 3^rd quarter earnings growth while bond markets have proven to be more volatile. The US Treasury 10-year yield, the benchmark for the corporate bond market, has risen 18% in the last two months to 4.30%. This is a result of the bond market anticipating slower and fewer rate cuts than what the Federal reserve anticipated and concerns over the inflationary impact of the proposed policies of the two presidential candidates. Expectations are for elevated volatility in coming weeks as additional clarity on the incoming presidential Administration and the Fed’s direction is found.

Hot jobs markets surprises many…

• The Department of Labor released its September jobs report on Friday containing a number of surprises. The Street expected the unemployment rate to stay at its most recent 4.2% level, and instead the reading came in lower at 4.1%. Further, employers added 254,000 new positions in September which was 40%+, or 100,000 more, than economists had anticipated.  Lastly, the report revised data from prior summer months to show that employers actually created an additional 72,000 more jobs than initially reported.

• Until this jobs report was released, investors were predicting that the Federal Reserve would cut the Fed Funds rate by a total of 1.25 percentage points before year end. Given the 0.50 percentage point rate cut last month, expectations for further rate cuts before year-end were high. As a result of this jobs report, analysts are now expecting much less aggressive action by the Fed’s rate setting committee. Partially as a result, the benchmark 10-Year Treasury rate has climbed almost 10% within the last month, to ~4.0%, a dramatic increase in an otherwise falling rate.

• Last week, the U.S. Bureau of Economic Analysis also released an upward revised final estimate of the 2^nd quarter U.S. GDP which showed an annual growth rate of 3.0%. In comparison, the year’ first quarter had a more tepid growth rate of 1.6%. With the more robust economic growth combined with the impressive jobs report, the economy is clearly better positioned than many had believed.  

• In addition to early earnings reports from several bellwether companies, this week will also have the latest update on the nation’s Consumer Price Index (CPI) and Producer Price Index (PPI), the two most popular inflation readings. Investors are expecting both numbers to continue their gradual descent, with the CPI reading expected to have an annual 2.3% rate increase and the PPI expected to print a 1.7% increase year over year growth rate. If these numbers are achieved, the markets will happily absorb this positive data.

And the Fed finally takes action!

•The day has finally come. Fed Chair Powell announced at his press conference last week that the Federal Reserve was cutting the Federal Funds rate by 0.50 percentage points. In the days leading up to the announcement, Wall Street odds had shifted to even on whether the Fed would cut by 0.25 percentage points or by 0.50 percentage points. The market largely rewarded the decision as stocks finished the week on a strong note.

•Moving forward it is currently being projected that the Fed will cut at least one, maybe two more times by the end of the year, for a potential of 1.25 percentage points in total rate decreases.  Expectations are that these rate reductions will help ease businesses’ lending expenses, aid consumer’s inflation-stretched budgets, and potentially slow the recently climbing unemployment rate.

•One effect of the central bank raising the Fed Funds rate so high was that it created an inverted yield curve, i.e., that short term interest rates were in the unusual position of being higher than long term rates. Now, anticipating the recent rate cut to the Fed Funds rate, the yield curve has started to return to its more typical upward slope as bond maturities lengthen. With a normalized yield curve, higher yields compensate for the increased risk involved in long-term loans and the lower risks associated with short-term investments.

•Later this week, the Fed’s preferred inflation measure, the Personal Consumption Expenditures (PCE), will be released. The market is anticipating a reading of a 2.7% annualized increase – similar to the readings of the last few months. As stated previously, the market has largely deemed the battle over inflation won. Now, it is to be determined whether unemployment can stop its gradual increase over the last 12 months and if the economy can actually stick a much hoped for “soft landing.”

Attention shifting to employment data…

• Markets continue their shift in focus away from inflation data points and towards the jobs data. Last Friday, the Labor Department released its August jobs report and Wall Street was not impressed. The popular S&P 500 index closed down 1.7% and ended the week with its largest weekly loss in 18 months. The labor report showed 142,000 jobs being added in August – far below the recent monthly average of 173,000 jobs. Meanwhile, the August unemployment rate, measured at 4.2%, maintaining its relatively elevated levels.

• There are growing fears if the job data continues its recent negative trend that the economy will sail past a possible soft landing and enter into recession. Central bankers will begin meeting next week to debate on the size of their first rate cut, either a 0.25 percentage point reduction or a larger 0.50 percentage point rate cut. Two weeks ago, the odds were evenly split between a large and a small rate cut. Today, forecasts sharply favor a more modest 0.25 percentage point cut. Only the first of a series of anticipated rate cuts, next week’s reduction is predicted to be the first step of an anticipated total 2.5 percentage point decline in overnight rates over the next 18 months.

• Supporting this position was Wednesday’s Consumer Price Index (CPI) report which showed inflation coming in slightly below expectations. The reading, at 2.5%, was modestly better than the predicted 2.6% increase in prices. While not yet at the Federal Reserve’s target of 2.0%, this report highlighted inflation’s ongoing decline and re-affirmed the belief that a Fed rate cut next week is an absolute certainty. The less important Producers Price Index (PPI), an inflation report based on the supply chain, report was released this morning and showed a 0.2% increase relative to a consensus forecast of 0.1%of 1.8%-2.0%. Markets have paid little heed to this report, considering it a less important outlier.

• Taking a quick look at the political situation, former President Trump and Vice President Kamala participated in their first debate earlier this week. Going into the debate, polls were largely a dead heat between the two presidential candidates. After the debate, the perception has largely been that Vice President Harris won although the two major predictive models still suggest that the election is a tossup. Expectations are high for a proposed additional debate between the two candidates.

Times, they are a changing…

• As Fed Chair Powell announced that “the time has come for policy to adjust” at his Jackson Hole speech last Friday. Of all of Powell’s recent public statements, this is the first time he has clearly and definitively communicated the central bank’s intention to start cutting the overnight Federal Funds rate. The question now is how much will the Fed cut and how frequently? The next Fed meeting is in three weeks, current forecast predicts a 70% chance of a 0.25 percentage point rate cut and a 30% chance of 0.50 percentage point rate cut.  Before year-end, predictions are for a 76% likelihood of a 1 percentage point reduction in the overnight interest rate.  In any scenario, we believe a larger initial rate cut would be unwarranted as it would likely spook the financial markets.

• When the Fed does begin cutting the overnight borrowing rate, it will have a significant impact across the fixed income markets. Rates that affect the average consumer such as credit card debt and home equity lines of credit should all be impacted. Most importantly, mortgage rates, which are largely priced upon the 10-Year US Treasury rate, should continue their recent drop as rate expectations have moderated over the last several weeks.

• This Friday the Fed’s preferred inflation gauge, the Personal Consumption Expenditures Price Index (PCE), for July will be released. The market is largely expecting this reading to continue its recent downward trend towards the Fed’s target goal of 2%. For the vast majority of this interest rate cycle, the PCE report has been the most watched report as the Fed placed increasing focus on reeling in inflation. At this point, the battle against inflation appears to largely be won. The Fed now is turning its attention to the labor market that has seen the unemployment rate recently increase to 4.3%, up markedly from last July’s 3.5% reading.

• Not helping the Fed newfound labor market attention was the Labor Department’s report last Wednesday which had surprising downward revision of 818,000 jobs created over the twelve months prior to March. Instead of adding on average 246,000 jobs a month, the U.S. economy added only 178,000 a month, or 28% fewer positions than had originally been believed. While economists had expected a downward revision, the revisions magnitude was unexpectedly large. Interestingly enough, the market took this news in stride and ended the day in the green.