Show Transcript
As it announced its 50 basis point interest rate cut, the U.S. Fed said it was confident inflation was on a clear path to 2%. Alexandra Gorewicz, Vice President and Director for Active Fixed Income Portfolio Management with TD Asset Management, tells MoneyTalk’s Greg Bonnell why the cut may best be described as risk management by the Fed.
Print Transcript
The US federal reserve surprising markets with a jumbo sized rate cut. So is this merely a recalibration as Chair Powell framed it, or is it signs of potential trouble ahead for the world's largest economy? Joining us now to discuss is Alex Gorewicz, VP and director for active fixed income portfolio management with TD Asset Management. Alex, great to have you back here on the program.
Thanks, Greg. Great to be here.
Good time to have a little chat too, about fixed income.
Very good.
Interest rates. We have been waiting, I think, of the past two years and then some of doing the show and having you as a regular guest and talking about the battle against inflation, the hike in borrowing costs awaiting this day, the day has arrived. How did you read it, though, 50 basis points out of the gate?
How do we characterize it? Probably we could do it in multiple ways. I've seen hawkish 50. I've seen, you know, rate cut of least regret. I'm going to use Powell's words to describe it and I'll call it a risk management cut, the 50 basis point.
Risk management. Recalibration perhaps was too polite. Risk management.
You know, maybe I'm getting a little cute here, but recalibration to me suggests some level of precision. I would have a hard time describing anything the Fed has done in the last nine months as very precise, when you think about the fact that June they had to drastically change their forecast for 2024 from what they had previously in march and December of last year. And now they've basically gone back to the March forecast. So all of this flip flopping doesn't really suggest a lot of recalibration, does it?
But I will say that I call it a risk management trade in that it's clear that the fed doesn't really know what's going to happen. It's clear they've been surprised first half of the year by very strong inflation prints, or at least stronger than expected inflation prints. And then in the last couple of months, they've been surprised by weaker than expected labor market data. And Powell admitted as much when he said, you know, if we had, had the labor, the July labor print heading into the July meeting, perhaps we would have cut then.
Wow. So it really is a battle about the job market now. I mean, they feel pretty confident, in his own words, that inflation will return to two. We've already returned to two, at least on a headline basis in this country. Is that still a wild card for them as well? I mean, the glide path seems to be going in a certain direction.
I do agree with that. The last CPI print, though, throws that a little bit into question. So obviously with, let's call it the commodity complex, headline inflation was expected to come off pretty quickly and it has. Core inflation, though, has seen a rebound for August vis a vis what happened in June and July, where, you know, core inflation, even super core inflation, when we strip out that sticky housing inflation that even Powell was asked about yesterday. When we strip all of that out, June and July were very weak from an inflation perspective. But August seemed to have flipped that a little bit.
So any sort of benign or weaker than expected inflation trends, it's too soon to tell if that has-- that was just sort of a blip and that has reversed. But certainly August didn't help. Now, on the labor market front, there's also a difference between it actually cracking, which we haven't really seen. You know, softening of labor market conditions because of supply side dynamics would suggest that, you know, service inflation won't necessarily be tepid going forward. So that bears close watching. But certainly additional softening might translate into stable inflation conditions. And if those are stable, even if they're above 2% the Fed will continue to cut.
Of course, you've been outlining there, the dual mandate, right. And the fed has to worry about jobs. They have to worry about inflation. At some point, are they going to be at odds with each other? Is it-- I think they're hoping for that situation. It's like, hey, look, if inflation just rolled back down to 2%, we can cut rates. The labor market is strong. That would be a lovely outcome for them. Is it going to be more trickier than that?
I think so, only because when things start to unfold, they they can unfold much quicker than forecast. And here's how I will frame it. In the presser, you know, Powell talked about the fact that they're recalibrating monetary policy, and he kept referring to the summer of last year. He mentioned July of last year.
I went to look at what the forecasts, the economic forecast that they had at that point in time for 2024. Now, I can appreciate at that time you were looking 18 months into the future. But what's interesting is that their forecast for 2024 were actually not too dissimilar from what we're getting. In fact, one positive surprise relative to their expectations from last year was or has been stronger than expected economic growth.
And if we look at, you know, some now casts on growth, they're actually suggesting Q3 is shaping up to be pretty good. So if their forecast last year was about half of what it's going to be this year and their employment projections are shaping in roughly the same, my question is, why are they penciling in a lower policy rate this year?
And I think part of that is because now that, that softness in the labor market is coming through, they don't know when it will stop.
Don't know when it'll stop. That sets us up very interesting for the rest of this year and into next year. Where do we think rates go from here? They start off with 50 basis points. We got another 50 coming?
We will get another 50, if again, that labor softening picks up steam. If we look at some of the higher frequency data points around the labor market, let's take claims that we had come in today, whether we're talking about initial jobless claims or continuing claims, they're suggesting that things are holding up pretty well in the labor market.
And again, any kind of softening then against this kind of backdrop where people aren't really losing their jobs en masse, there might be job losses here and there, but nothing significant. If it means that labor market continues to soften again from the supply side, just more people entering the market, but not necessarily finding jobs, I think you'll find a more gradual pace to rate cuts.
If that doesn't happen, if people start really losing jobs, I don't think that you'll get 50s. I think you could get even more than that.
More than 50s, contingent on the weakening labor market?
Correct and that's just because, you know, the way they've characterized it is, well, the labor market's still strong. And against that backdrop, they cut 50. What do you think happens if that weakness comes through much faster?
And Powell again stressed, look at our statement of economic projections. That is basically your benchmark for determining how fast we will go from here. So anything that comes in weaker than their forecasting, suggests they could speed it up.
All right. Very intriguing stuff. What does it all actually mean when we take it back to fixed income to the bond market?
So the bond market over the last 12 months has actually put up some decent returns, right, high single digits. We're talking in the 8 to 9% vicinity, and that's largely come through the bond market pricing in a pretty decent amount of rate cuts over the next couple of years. But also just that income return yields have generally been very high in this cycle.
Now, the way that I characterize the outlook from here is still positively skewed in terms of total returns. Now, I'm not guaranteeing performance, but what I'm saying is that if we get a gradual reduction in the policy rate from here and that's relatively priced into the bond market right now, you're looking at clipping yields, an investment grade landscape of, we'll call it somewhere between 4 to 4 and a half percent, mid-single digit returns.
If it turns out that the economy weakens and in particular, the labor market weakens a lot faster and the Fed has to start cutting more aggressively than what's priced in or what they're saying in their dot plot, if they have to revise that dot plot even lower, then I think you're looking at probably high single digits again for the next 12 months, in terms of total returns in bond land.
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The US federal reserve surprising markets with a jumbo sized rate cut. So is this merely a recalibration as Chair Powell framed it, or is it signs of potential trouble ahead for the world's largest economy? Joining us now to discuss is Alex Gorewicz, VP and director for active fixed income portfolio management with TD Asset Management. Alex, great to have you back here on the program.
Thanks, Greg. Great to be here.
Good time to have a little chat too, about fixed income.
Very good.
Interest rates. We have been waiting, I think, of the past two years and then some of doing the show and having you as a regular guest and talking about the battle against inflation, the hike in borrowing costs awaiting this day, the day has arrived. How did you read it, though, 50 basis points out of the gate?
How do we characterize it? Probably we could do it in multiple ways. I've seen hawkish 50. I've seen, you know, rate cut of least regret. I'm going to use Powell's words to describe it and I'll call it a risk management cut, the 50 basis point.
Risk management. Recalibration perhaps was too polite. Risk management.
You know, maybe I'm getting a little cute here, but recalibration to me suggests some level of precision. I would have a hard time describing anything the Fed has done in the last nine months as very precise, when you think about the fact that June they had to drastically change their forecast for 2024 from what they had previously in march and December of last year. And now they've basically gone back to the March forecast. So all of this flip flopping doesn't really suggest a lot of recalibration, does it?
But I will say that I call it a risk management trade in that it's clear that the fed doesn't really know what's going to happen. It's clear they've been surprised first half of the year by very strong inflation prints, or at least stronger than expected inflation prints. And then in the last couple of months, they've been surprised by weaker than expected labor market data. And Powell admitted as much when he said, you know, if we had, had the labor, the July labor print heading into the July meeting, perhaps we would have cut then.
Wow. So it really is a battle about the job market now. I mean, they feel pretty confident, in his own words, that inflation will return to two. We've already returned to two, at least on a headline basis in this country. Is that still a wild card for them as well? I mean, the glide path seems to be going in a certain direction.
I do agree with that. The last CPI print, though, throws that a little bit into question. So obviously with, let's call it the commodity complex, headline inflation was expected to come off pretty quickly and it has. Core inflation, though, has seen a rebound for August vis a vis what happened in June and July, where, you know, core inflation, even super core inflation, when we strip out that sticky housing inflation that even Powell was asked about yesterday. When we strip all of that out, June and July were very weak from an inflation perspective. But August seemed to have flipped that a little bit.
So any sort of benign or weaker than expected inflation trends, it's too soon to tell if that has-- that was just sort of a blip and that has reversed. But certainly August didn't help. Now, on the labor market front, there's also a difference between it actually cracking, which we haven't really seen. You know, softening of labor market conditions because of supply side dynamics would suggest that, you know, service inflation won't necessarily be tepid going forward. So that bears close watching. But certainly additional softening might translate into stable inflation conditions. And if those are stable, even if they're above 2% the Fed will continue to cut.
Of course, you've been outlining there, the dual mandate, right. And the fed has to worry about jobs. They have to worry about inflation. At some point, are they going to be at odds with each other? Is it-- I think they're hoping for that situation. It's like, hey, look, if inflation just rolled back down to 2%, we can cut rates. The labor market is strong. That would be a lovely outcome for them. Is it going to be more trickier than that?
I think so, only because when things start to unfold, they they can unfold much quicker than forecast. And here's how I will frame it. In the presser, you know, Powell talked about the fact that they're recalibrating monetary policy, and he kept referring to the summer of last year. He mentioned July of last year.
I went to look at what the forecasts, the economic forecast that they had at that point in time for 2024. Now, I can appreciate at that time you were looking 18 months into the future. But what's interesting is that their forecast for 2024 were actually not too dissimilar from what we're getting. In fact, one positive surprise relative to their expectations from last year was or has been stronger than expected economic growth.
And if we look at, you know, some now casts on growth, they're actually suggesting Q3 is shaping up to be pretty good. So if their forecast last year was about half of what it's going to be this year and their employment projections are shaping in roughly the same, my question is, why are they penciling in a lower policy rate this year?
And I think part of that is because now that, that softness in the labor market is coming through, they don't know when it will stop.
Don't know when it'll stop. That sets us up very interesting for the rest of this year and into next year. Where do we think rates go from here? They start off with 50 basis points. We got another 50 coming?
We will get another 50, if again, that labor softening picks up steam. If we look at some of the higher frequency data points around the labor market, let's take claims that we had come in today, whether we're talking about initial jobless claims or continuing claims, they're suggesting that things are holding up pretty well in the labor market.
And again, any kind of softening then against this kind of backdrop where people aren't really losing their jobs en masse, there might be job losses here and there, but nothing significant. If it means that labor market continues to soften again from the supply side, just more people entering the market, but not necessarily finding jobs, I think you'll find a more gradual pace to rate cuts.
If that doesn't happen, if people start really losing jobs, I don't think that you'll get 50s. I think you could get even more than that.
More than 50s, contingent on the weakening labor market?
Correct and that's just because, you know, the way they've characterized it is, well, the labor market's still strong. And against that backdrop, they cut 50. What do you think happens if that weakness comes through much faster?
And Powell again stressed, look at our statement of economic projections. That is basically your benchmark for determining how fast we will go from here. So anything that comes in weaker than their forecasting, suggests they could speed it up.
All right. Very intriguing stuff. What does it all actually mean when we take it back to fixed income to the bond market?
So the bond market over the last 12 months has actually put up some decent returns, right, high single digits. We're talking in the 8 to 9% vicinity, and that's largely come through the bond market pricing in a pretty decent amount of rate cuts over the next couple of years. But also just that income return yields have generally been very high in this cycle.
Now, the way that I characterize the outlook from here is still positively skewed in terms of total returns. Now, I'm not guaranteeing performance, but what I'm saying is that if we get a gradual reduction in the policy rate from here and that's relatively priced into the bond market right now, you're looking at clipping yields, an investment grade landscape of, we'll call it somewhere between 4 to 4 and a half percent, mid-single digit returns.
If it turns out that the economy weakens and in particular, the labor market weakens a lot faster and the Fed has to start cutting more aggressively than what's priced in or what they're saying in their dot plot, if they have to revise that dot plot even lower, then I think you're looking at probably high single digits again for the next 12 months, in terms of total returns in bond land.
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