Higher for longer: Sticky inflation pushes U.S. rate cut hopes further out

[MUSIC PLAYING]

The US Federal Reserve has held rates steady and also signaled that it may be some time before they make a cut. Joining us now to discuss is Sam Chai, vice president for Active Fixed Income Portfolio Management at TD Asset Management. Sam, thanks for joining us today.

Thank you for having me here.

OK, so walk us through the Fed's decision and what we heard from the Chair Powell.

For sure. So yesterday, the Fed has decided to hold policy rate unchanged. They have also announced a partial tapering of their quantitative tightening program. That has largely conformed to both market expectations and ours because we know that, since the last FOMC meeting, US inflation has surprised to the upside.

In fact, for three months in a row, core PCE inflation has surprised to the upside. And that really warranted a rethinking of the policy path and a reset of forward guidance. But at the same time, we know from just recent Fed communications as well that they have been saying that the policy is well-positioned and that the policy is restrictive. And so it's reasonable, then, that the Fed decide to basically hold the policy rate at the current level, but just for longer, for as long as needed until we see further disinflation progress.

Looking forward, the forward guidance that the Fed gave remains relatively unchanged. They need to see-- they need to have greater confidence in the disinflation progress before commencing a rate cut. But given the lack of disinflation progress in the first quarter, they just believe that it may take a bit longer than previously expected for that confidence to be attained, which points to potentially, say, a first cut in later second half of this year.

OK. Now, inflation was a key message. Another key message was the Fed's balance sheet, which we saw there were some changes to that. What's changed? And what impact will that have?

So just a quick recap on the current quantitative tightening program the Fed has. Currently, Fed allows up to $60 billion per month of United States Treasury security to basically mature and run off its balance sheet, and roughly $35 billion per month max of agency debt or agency mortgage-backed securities to run off its balance sheet. And the goal is basically to gradually reduce Fed's size of balance sheet and also tighten market liquidity, which complements their current restrictive stance on the monetary policy rate front as well.

Yesterday's decision basically have reduced that cap of allowed runoff of the US Treasury securities from $60 billion to $25 billion per month. In other words, Fed essentially is basically providing $35 billion less net supply to private investors, which marginally should be helping lowering the term premium in the US rates market.

I wouldn't say it's a surprise to the market, in general, for the QT announcement, because we already know that even in the prior FOMC meeting, there has already been discussion about potential tapering of the QT program. It's really that the size of the tapering is slightly larger than what market expected. The market expected to go from $60 billion to $30 billion, but it's a bit lower to $25 billion.

OK, so the message wasn't a surprise, just the size of that reduction was--

That's slightly dovish.

Slightly dovish. OK. So now "higher for longer" was the message. And we're beginning to see cracks in the US labor market from these elevated rates. Is that correct?

I would characterize it more as we are seeing better demand supply rebalancing in the US labor market. Why do I say that? Because when you look at the US unemployment rate, it currently stays around at 3.8%, and already there for a few months, which is near the historical low. If you look at the past three months of monthly job gains, it averaged over 250,000 per month.

By any means. It's quite healthy as well. But on the other hand, if you look at other leading indicators, including, say, the jobs number that just got released in the US yesterday, we see a consistent decline of job openings in the US since 2022.

There seems to be some tightening there.

For sure. So that job opening gap is definitely coming down. If you look at the job opening versus the unemployment ratio, that has also been coming down gradually. So the picture it paints overall is really that it's a very tight labor market, but the tightness is starting to gradually alleviate. So it's more the supply demand coming into better balance.

Tomorrow, we'll get the Fed's April monthly job print again for the US, which is key to watch. We will see that going into Q2. Do we see continued solidness in the labor market, or do we start to see maybe some moderation in the job trend?

OK. Now, what are you expecting on the inflation front going forward given this backdrop?

Yeah. So I want to take just one sentence from Chair Powell, which he mentioned yesterday, which is that one or two months of upside inflation price does not a trend make. But when we have seen three monthly upside in the PCE inflation prints, I think it's prudent to take a signal from there. And the signal could be that the disinflation progress is likely to be bumpy and perhaps the last mile is stickier than expected.

Our base case right now, we continue to see that because of the restrictive level of policy rate right now, we expect that there could be some potential more recovery on the supply side. And at the same time, we could see a bit more moderation on the demand side as well just looking at some of the soft data in US that's coming in a bit weaker now. The implication is that we could see a bit more slowdown in the inflation momentum in the second half this year.

That being said, uncertainty is obviously very high. As I mentioned earlier, the disinflation progress is likely going to be bumpy. So we will continually be updating our inflation forecast trajectories as well as our understanding of what's the key underlying drivers driving those inflation pressure as we get more incoming data.

So given that environment, what might the path of interest rates look like? Are we still expecting a cut or cuts from the Fed this year?

I would summarize by saying that the next likely move from the Fed will continue to be a cut. I see two primary paths where the economic scenario could manifest into allowing the Fed to deliver a cut. The first one being that we get a few consecutive months of good disinflation print that allows the Fed to really attain this greater level of confidence-- hence cutting.

The second path is that we have a significant deterioration in labor market or economic activity data relative to expectations. So that really changes the balance of risk consideration of Fed's dual mandate. That could also lead to a cut. Admittedly, neither path is currently in sight given the current data, hence is why it makes sense for Fed to prefer to hold rates higher for longer until we see more data evidence.

But in the meantime, I'd also point out that, yes, there is a narrow path to a potential hike as well. But that path is considerably narrower than the other two paths. And for that to occur, we likely need to see a re-celeration of Q2 inflation even more than Q1, and possibly because of a negative supply shock. And if that manifests, then the Fed could deliver a hike. But for us, probably that scenario is relatively low.

So overall, if we look at the upside versus downside surprise-- downside risk to our rates forecast, I would incline to say that the risk is tilted to slightly more cuts being priced in the US market over the next 12 months, especially when you consider that there is just now over one cut being priced in in the US market by the end of this year. And it's interesting to point out that it's quite a contrast to at the beginning of the year when we have six to seven cuts priced in the Fed. So the downside-upside risk has really shifted there.

[MUSIC PLAYING]