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The Fed and a new frontier · UBS Trending

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It was an eventful weekend in Jackson Hole,
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where the question wasn't
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whether the central bank will cut rates in September,
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but by how much?
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As we know,
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inflation has been receding and the job market has been stable.
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So what might the new frontier look like?
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We're going to break that all down for you right now.
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On UBS trending.
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Hi everyone, and welcome to another episode of UBS trending.
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I'm Anthony Pastore.
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Thank you, of course, for being with us today.
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My guest is none other than my friend and colleague Leslie Falconio
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from the Chief Investment Officer.
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Leslie, always good to have you.
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I know every time we get you here,
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I always feel like there's a lot to talk about.
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And we're coming off of a Jackson Hole weekend.
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I want to get into the fed, the economy,
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and of course, fixed income, fixed income with you.
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So great to have you on the show.
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So let's let's get
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let's get right into it Leslie Jay Powell of course is the,
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head of the Federal Reserve
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says, and I quote,
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the time has come for the fed to cut interest rates.
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So he was pretty blunt
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in saying that
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he knows that this is the time that we're going to be getting into.
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So what do you think is the current economic plan,
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the system, the path ahead for monetary policy as you see it?
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Well, you
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know, it's
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interesting, Anthony, because, you know, what do you think about,
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you know, a lot of his testimony months back, right.
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What he thought of what he would address the labor market.
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He always wanted the labor market to cool. Right.
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Because a cooling labor market would mean that,
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you know, inflation could slow down because wages would slow down.
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So he would always say, we need,
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you know, the labor
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market to cool to have a consumer demand come down.
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Now as we've had, you know, 13 months of a,
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you know, unsold fed and a 5.33 effective funds
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rate for that, you know, 13 month time period.
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You know,
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we have seen a little bit of loosening in the labor market.
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And you know he he addressed this in terms of,
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you know,
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they don't want to see it
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cool by anymore,
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which is much different than the dialog
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that he had eight months ago.
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But he also made the point of Wally.
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Wally really emphasized or spoke about, you know,
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quit rates, you know, lower job vacancies.
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The layoffs are very low.
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So, I mean, I think the important part with that
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and as he addressed too,
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that, you know, inflation is coming down
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not at the target but heading in the right direction.
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You know, we've had CPI coming down for, you know, four months now.
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You know, it's at a level that we haven't seen since April of 2021.
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So that dual mandates coming into play.
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And now they're ready to cut.
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But that the thing is is that when we know the fixed income
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market has a tendency to really be forward looking
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and the fed is backward looking,
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so what happens is,
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is that the fixed income market has a tendency to get a little bit
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ahead of itself in terms of pricing and cuts,
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which they're doing right now.
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So they have almost
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over 200 basis points of cuts priced in through 2025.
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And they have a terminal rate that's about 3.2%,
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which what do you think about that is relatively
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low given the fact that we expect a soft landing.
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And one of the things that we emphasize, too,
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even with the employment, is,
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you know, this is a normalization, right?
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The economy is normalizing. It's not collapsing.
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Yeah,
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that's a really good way to say it,
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because as we as you just said,
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Jay Powell has indicated
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that we're on the right path towards inflation.
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Again, we're not at that 2% target that the fed
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has been so adamantly trying to go for.
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But we're on the way there.
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And as you said, the labor market is cooling.
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So if the fed now by the way, let me back up
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and say
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our forecast here from our chief investment office,
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our own economist Brian Rose, is expecting 100
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basis points in cuts between September and the end of the year.
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So whether or not they cut 25 or 50 at the meeting in September,
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what do you think is going to happen following that, especially
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when you're looking at rates,
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when you're looking at the direction of, especially fixed income,
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where you really spend your time for investors?
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Yeah, I mean, this is really important.
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And that's actually a great question
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because let's go back to what I just mentioned,
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what is priced into the marketplace.
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And I think that a lot of investors don't realize that the variance
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that comes from fixed
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income and interest rates
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is that deviation of what's already priced debt.
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Right?
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If you have a GDP number of X and it comes
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in, you know, X plus ten, then interest rates rise, right.
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If it comes in lower than it rates go down.
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So it's really the variance of what's already priced in.
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And right now the market is pricing in as I mentioned over 200
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basis points of cuts through 2025.
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Now the 25 and 50 right will actually,
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in my opinion, be a difference in terms of how rate the rate
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will move on that, you know, the next FOMC meeting.
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And this is really going to rely on or really be linked
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towards the nonfarm payroll report on the sixth.
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So if in fact hypothetically we get
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you know
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right now Bloomberg just just a basic Bloomberg projection.
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Right. It's very early.
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But the preliminary projections about a 4.2% unemployment rate
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and not for a payroll about 150,000.
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Now, in that scenario, they would probably only go 25
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basis points on the September FOMC cut by 25.
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If in fact, the number comes out, say, a 4.5 or 4.6 unemployment
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rate and only,
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you know, 70 to 100,000 in payroll, then they're going to go 50.
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So the market right now
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is pricing in about a 25% possibility of a 50 basis point cut.
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So what happens if if they actually do do go 50,
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it will be because of a weaker
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jobs market than the market was expecting.
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And in that scenario, interest rates
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are probably going to continue lower
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because it's going to be something that the market isn't
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foreseeing in terms of much weaker economic data
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in this, in the short term time period,
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if they only go 25, the market's kind of projecting that.
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So it's really going to be dependent on what they caveat
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in terms of their statement, the S&P projections
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how the Q&A works out.
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But right now like a simple 25,
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I'm not necessarily fully convinced
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you're going to rally any more on interest rates
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because of what's priced in.
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You could actually end up going the other way
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because if, in fact, the nonfarm payroll report is stronger
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than what people think, or even on target,
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then you kind of have those that the investor saying, you know,
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the fed, being once an inflation vigilante, is no longer doing that
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because they're cutting rates.
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And what's interesting is
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if you look back on Friday's Jackson Hole, right as it came across,
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you know,
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people thought it was a little bit more dovish,
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even though the market was expecting a dovish outcome.
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Inflation expectations and the Tips market actually rose.
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And they rose
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because the cut was pretty cemented in stone for September.
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And therefore you're not being that vigilante and inflation side
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they once were.
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And the market gets a little bit nervous right.
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You know interesting Leslie something I want to go to with
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you is just recently there was a revision
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by by the Labor Department of Jobs.
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I guess the jobs were overestimated by something
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like 850,000 875,000.
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But still, even with that number, there was we're still at,
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historic lows
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for unemployment at 4.3%, which if you look at a chart over
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the last 40 years, it's still at the lowest level.
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Does this have anything to do with the dollar weakening?
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What do you think is the root cause
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of this recount of jobs that everybody's looking at?
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You know, let's say that that that revision only went to March.
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And even when you take that revision into consideration,
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it's still about a, you know, three month moving about 170,000.
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So it still is a very strong jobs number.
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But as we know, and as we see
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people talk about things like the same rules, you know, it's
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very difficult in terms of when we look at some things,
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you know, a
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supply driven environment because of immigration, right.
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Or the important part is the unemployment due to layoffs.
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Okay.
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Those are two type two different types of outcomes,
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two different types of inputs to the long term,
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path of the economy.
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If it's something that was a lot of layoffs,
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that would be a different story.
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Like we saw layoffs shoot up in a very much different than,
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you know,
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more of a balancing in terms of what we've seen from immigration.
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So I don't think that Shirley does really have anything to do with
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with the dollar per se.
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I mean, obviously,
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you know, the more the fed cuts, the more the dollar goes down.
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And we saw that last week.
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It hit close to its yearly low.
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And if in fact, the economy starts to slow
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and they cut more than what the market's pricing in that
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dollar is going to continue its downward trend.
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But I think I think the employment part is why we have these
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such large variances is really, really tough.
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And that's
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why it's important not to just to look at the unemployment,
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but you have to look at things
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like claims like weekly claims numbers.
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Those are really sort of the and I'm not saying
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that they don't have their nuances either, because they do.
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But I mean, at least they are more of the backbone to
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is the is the market facing or the potential facing
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large future layoffs going down the line?
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Right.
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If you have a lot of layoffs, then, you know, people
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don't spend and then businesses, they lose
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and they have to layoff more.
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And it kind of circular keeps going and going.
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But we're not seeing that yet.
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And that's the part
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that's really the part of the piece of the puzzle
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that layoffs might rise.
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But we don't think it's going to get to a point where it becomes
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really a challenge to the economy,
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that it's more of a hard landing. Right.
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We think again, that the the inflation and all
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and the growth will slow, but it'll normalize.
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And we always say, you know, it's going to get weaker but not weak.
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The same with the left layoffs.
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I'm sure it will rise in time.
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But it's not going to be one
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where the rise turns into an economic collapse, right?
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Yeah. I'm thank you for pointing that out.
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I think, you know,
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when that number first came out,
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I think a lot of people held their breath on it.
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But still,
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when you look at
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what the actual numbers are and you look at other factors like CPI
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and the jobless claims, it actually seems to be less
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severe than what I think a lot of folks were concerned about.
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And we're still, again, at historic unemployment levels.
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So, Leslie,
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let me ask you,
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because we're looking at you and I talk about the ten year U.S.
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Treasury yield all the time.
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And as everybody does, because it's the benchmark,
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it's sitting at around a 3.85% or so right now,
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and it's about 90 basis points lower than it was in April.
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So only a couple of months do you see a more limited
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kind of scope for gains over our forecast horizon,
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especially if we're looking at this soft landing scenario
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to play out.
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What are your thoughts there?
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Yeah, I mean, I think you're absolutely right
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to say at least in the short term, right?
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We we've gotten down to about a 366 365
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during the volatility that we saw in the beginning of August.
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But I do think for the short term, we've kind of played this out
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because the market is pricing in, you know, a lot of cuts.
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It is pricing in a really a very fairly low terminal rate
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in our opinion.
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And given that's already priced in, in order for you to really move
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lower, you have you would have to see a weak non-farm, right.
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You'd have to see weakness in data
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and that just speculation that the data will come in weaker.
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You have to actually see it.
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And I think that that's a big difference.
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And even then when you look, you know,
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at some of these credit markets and fixed income, you know, listen,
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you know these spreads, credit spreads
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are actually fairly compressed.
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So we lower credit quality
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things like high-yield are still at a very low level.
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So while the Treasury market might have moved down and said
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okay, growth is slowing,
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the credit market
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in the equity market, for that matter,
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is really not saying that, right.
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It's saying it's not saying that at all.
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It's actually has compressed
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and, you know, it would be on the tighter side,
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but on a yield sort of basis.
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And that's
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what actually this chart
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showing that you're looking at right now at a yield basis,
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it's actually, you know, fixed income is still very high in terms
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of what was see in the past, you know, 20, 25 years.
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So if I could pick up a 5% investment grade, corporates
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that still say at the 80th percentile over the past 20,
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20 years,
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which means only 20% of the time,
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but they've been higher than they are today.
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And if you have the ability
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to lock that in and earn and compound that income,
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it is a good time to particularly since they're now
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finally outperforming cash.
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And because we've had this inverted yield curve
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for such a long time,
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understandably, a lot of people have parked their money in cash
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to earn that incremental yield
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because the yield curve has been inverted.
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And once they're in fixed income as a show me market it.
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Once they start
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that reinvestment risk is going to really start to unfold.
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So that's why we like locking into higher quality.
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Absolutely.
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And as you say on every show,
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Leslie, the best thing to do is
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have that conversation with your financial advisor.
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As things are set to change,
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you want to make sure that your portfolio
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is ready for those changes.
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Leslie, thank you so much.
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Always good to have you here, my friend.
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Great to see you.
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Thank you. Thanks, Leslie.
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And for more information on everything
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that Leslie and I spoke about,
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make sure to visit our insights website at ubs.com/views.
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Plus,
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you can follow us on social media where all the major channels like
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12:22
Plus, you can check out our dedicated Instagram channel at UBS.
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Trending. It's right there on your screen.
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Give us a follow there for lots of content
12:29
that you're not going to find anywhere else.
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And as always again, make sure you're having
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that conversation with your financial advisor.
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Until next time, I'm Anthony Pastore.
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You have a great rest of your day. Everyone.
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And remember to keep your eyes on what's trending.
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We'll see you soon.