The U.S. Federal Reserve has signaled an interest rate cut may not come as fast as some had expected. Sam Chai, Vice President, Active Fixed Income Portfolio Management at TD Asset Management, discusses the potential timing of a Fed rate cut and the implications for fixed income with MoneyTalk’s Greg Bonnell.
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Markets are digesting the latest Fed rate decision, Chair Powell suggesting that rate cuts may not be coming as quickly as investors may have thought. Joining us now to discuss, Sam Chai, VP of Active Fixed Income Portfolio Management at TD Asset Management. Sam, great to have you. Welcome to the program.
Thank you for having me here, Greg.
So it was an interesting decision not in the fact that no decision was made-- that was fully anticipated-- but this push and pull that we've seen between what the market expects the Fed and other central banks to do this year, and what the central banks tell us they're going to do. Walk us through a bit of that. I mean, what did we ultimately hear from Chair Powell that got the markets a little upset?
For sure. So in terms of the Fed decision yesterday, firstly, the Fed has kept the interest rate unchanged, keeping a target range of 5.25 to 5.5%, which is generally conforming to market expectations. More notably, the Fed has basically changed their forward guidance from having an explicit hiking bias to now having a neutral stance on future policy direction. They have also added a language in a statement, which is that they do not see necessarily that they will be able to lower interest rates until they gain greater confidence that inflation comes sustainably towards their 2% target.
So I would say that overall, the policy statement generally is in line with market expectations. When you look at the broader US macro picture, in the most recent weeks, labor market has been solid. Activity data has coming in more resilient than expected. Inflation data, though, has coming in better than expected.
And when you look at core PCE measures, which is the Fed's favorite inflation measure, six month annualized core PCE is now below 2%. In other words, the Fed has already seen six months of good inflation data, but they just want to see more. So it's reasonable now to see that the Fed wanted to basically pare back their hiking bias to a neutral stance to lay the groundwork for potential rate cuts sometime in the future.
When I think about the market reaction, the equity side seemed to take it a lot tougher, that message, which he's been delivering all along, really. Let's see inflation get back to 2% and be on that path before we make any cuts. The equity markets sold off. The bond market sort of just held in. And even now, bonds seem to be on the rally. It's interesting to see that kind of dynamic. Did the equity market get a little bit of ahead of itself in thinking what the Fed is going to get up to?
So it's interesting you pointed out that discrepancy in the two markets. So I would say that for the rates market, we have seen that after the statement get released the US interest rates actually rose for a few beeps initially, because the market interpreted this language that they need greater confidence in order to cut to be slightly erring on the hawkish side. But going into the press conference, the message from Powell has been a bit more mixed. And so we have a pretty volatile intraday moves, like, on the rate side during the press conference.
But after the conference, US interest rate has seen a sustained rally until the end of the day. On net, we have seen roughly 10 beeps lower on US 10-year rates. So that has been a positive obviously, for the bonds. On the other hand, for the equity market, there might have been anticipation of a more imminent rate cut. And with that not in the near term, that has on net led to roughly 1% of SPX index sell off from the beginning of the conference till the end of it.
Right. So interesting reaction there. As we think about-- and we've had a little time in the markets calming down a little bit, they've had some time to take a breath, think about what Chair Powell actually said, what it could mean for the path forward-- what are we thinking now about rate cuts? Because at some point-- at one point, March seemed to be in play. It doesn't seem to be the story now.
Yeah, so thankfully, Chair Powell had provided some guidance on that particular question. I would first say, though, that the Fed has taken an important step of basically turning their forward guidance from hiking bias to neutral, because again, that essentially laid the groundwork for a potential cut sometime down the road. So all future meetings are live. My base case would be that I expect a rate cut to materialize sometime in the second quarter this year.
Post-Powell's, you know, guidance on the March meeting cut likelihood. The market has priced a March cut to be roughly now around 30% chance. And personally, I think that's a fair assessment. And for this view of the first cut materialize in Q2, obviously, that would be conditional on us seeing more good inflation data over the coming months.
Obviously, there are risks to that to that view. On the one hand, we have seen pretty good core PCE data over the past months. Maybe that progress stalls in the last mile of this journey. And if this inflation is slowing down, then we may see the Fed having to delay this rate cut sometime to the second half this year.
On the other hand, this inflation progress could accelerate. Or perhaps, labor market could deteriorate slightly faster than expected. If that's going to materialize, then the Fed will have to cut more aggressively and faster. And so there will be a lot of data dependency on that.
Let's take all of this, put it together to what it means for the fixed income investor in 2024. How should we be thinking about that space?
Sure. So I would think about it in two components. Firstly, if we look at the shorter tenor of the interest rate curve, I would say that my personal view is quite aligned with when the market is going to deliver the first rate cut, which is sometime in Q2. But when you look at how many cuts the market has priced in for the Fed this year, that's just shy of six cuts.
Based on my personal macro view, I would think that that's slightly excessive. Although, I would acknowledge that I think the risks to my macro view is slightly to the downside. For instance, when labor market reaches an inflection point, that unemployment rates start to rise, labor market could deteriorate much faster than expected, and unemployment rate rise more than expected, which is not uncommonly seen in prior cycles.
And so if that scenario is going to come to be realized, then the Fed will have to cut more aggressively and earlier. And the total number of cuts we have this year will be materially above the six cuts the market currently priced in.
And of course, the assumption from investors would be that would set off a rally in bonds, right? You start seeing this aggressive pull back in the Fed's funds rate, then we're going to see that bond rally we've been sort of keeping our eye on, waiting for.
For sure. And if we take our eye now to the longer tenor of the interest rate, if you look at the overnight index swap market, the actual average long-term rate currently priced in is roughly around 3.5%, which is materially higher than the long-term neutral rate that the Fed currently forecasts, which is 2.5%. So there seem to be some room for that average long-term rate currently priced in to come down.
And so that's going to contribute positively to longer-term US Treasury bonds. Additionally, term premia currently on those bonds are also at relatively elevated level compared to where we have seen over the past years. So we also think that that is going to be a positive factor contributing to better expected returns of long-term treasury bonds. [AUDIO LOGO]
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Markets are digesting the latest Fed rate decision, Chair Powell suggesting that rate cuts may not be coming as quickly as investors may have thought. Joining us now to discuss, Sam Chai, VP of Active Fixed Income Portfolio Management at TD Asset Management. Sam, great to have you. Welcome to the program.
Thank you for having me here, Greg.
So it was an interesting decision not in the fact that no decision was made-- that was fully anticipated-- but this push and pull that we've seen between what the market expects the Fed and other central banks to do this year, and what the central banks tell us they're going to do. Walk us through a bit of that. I mean, what did we ultimately hear from Chair Powell that got the markets a little upset?
For sure. So in terms of the Fed decision yesterday, firstly, the Fed has kept the interest rate unchanged, keeping a target range of 5.25 to 5.5%, which is generally conforming to market expectations. More notably, the Fed has basically changed their forward guidance from having an explicit hiking bias to now having a neutral stance on future policy direction. They have also added a language in a statement, which is that they do not see necessarily that they will be able to lower interest rates until they gain greater confidence that inflation comes sustainably towards their 2% target.
So I would say that overall, the policy statement generally is in line with market expectations. When you look at the broader US macro picture, in the most recent weeks, labor market has been solid. Activity data has coming in more resilient than expected. Inflation data, though, has coming in better than expected.
And when you look at core PCE measures, which is the Fed's favorite inflation measure, six month annualized core PCE is now below 2%. In other words, the Fed has already seen six months of good inflation data, but they just want to see more. So it's reasonable now to see that the Fed wanted to basically pare back their hiking bias to a neutral stance to lay the groundwork for potential rate cuts sometime in the future.
When I think about the market reaction, the equity side seemed to take it a lot tougher, that message, which he's been delivering all along, really. Let's see inflation get back to 2% and be on that path before we make any cuts. The equity markets sold off. The bond market sort of just held in. And even now, bonds seem to be on the rally. It's interesting to see that kind of dynamic. Did the equity market get a little bit of ahead of itself in thinking what the Fed is going to get up to?
So it's interesting you pointed out that discrepancy in the two markets. So I would say that for the rates market, we have seen that after the statement get released the US interest rates actually rose for a few beeps initially, because the market interpreted this language that they need greater confidence in order to cut to be slightly erring on the hawkish side. But going into the press conference, the message from Powell has been a bit more mixed. And so we have a pretty volatile intraday moves, like, on the rate side during the press conference.
But after the conference, US interest rate has seen a sustained rally until the end of the day. On net, we have seen roughly 10 beeps lower on US 10-year rates. So that has been a positive obviously, for the bonds. On the other hand, for the equity market, there might have been anticipation of a more imminent rate cut. And with that not in the near term, that has on net led to roughly 1% of SPX index sell off from the beginning of the conference till the end of it.
Right. So interesting reaction there. As we think about-- and we've had a little time in the markets calming down a little bit, they've had some time to take a breath, think about what Chair Powell actually said, what it could mean for the path forward-- what are we thinking now about rate cuts? Because at some point-- at one point, March seemed to be in play. It doesn't seem to be the story now.
Yeah, so thankfully, Chair Powell had provided some guidance on that particular question. I would first say, though, that the Fed has taken an important step of basically turning their forward guidance from hiking bias to neutral, because again, that essentially laid the groundwork for a potential cut sometime down the road. So all future meetings are live. My base case would be that I expect a rate cut to materialize sometime in the second quarter this year.
Post-Powell's, you know, guidance on the March meeting cut likelihood. The market has priced a March cut to be roughly now around 30% chance. And personally, I think that's a fair assessment. And for this view of the first cut materialize in Q2, obviously, that would be conditional on us seeing more good inflation data over the coming months.
Obviously, there are risks to that to that view. On the one hand, we have seen pretty good core PCE data over the past months. Maybe that progress stalls in the last mile of this journey. And if this inflation is slowing down, then we may see the Fed having to delay this rate cut sometime to the second half this year.
On the other hand, this inflation progress could accelerate. Or perhaps, labor market could deteriorate slightly faster than expected. If that's going to materialize, then the Fed will have to cut more aggressively and faster. And so there will be a lot of data dependency on that.
Let's take all of this, put it together to what it means for the fixed income investor in 2024. How should we be thinking about that space?
Sure. So I would think about it in two components. Firstly, if we look at the shorter tenor of the interest rate curve, I would say that my personal view is quite aligned with when the market is going to deliver the first rate cut, which is sometime in Q2. But when you look at how many cuts the market has priced in for the Fed this year, that's just shy of six cuts.
Based on my personal macro view, I would think that that's slightly excessive. Although, I would acknowledge that I think the risks to my macro view is slightly to the downside. For instance, when labor market reaches an inflection point, that unemployment rates start to rise, labor market could deteriorate much faster than expected, and unemployment rate rise more than expected, which is not uncommonly seen in prior cycles.
And so if that scenario is going to come to be realized, then the Fed will have to cut more aggressively and earlier. And the total number of cuts we have this year will be materially above the six cuts the market currently priced in.
And of course, the assumption from investors would be that would set off a rally in bonds, right? You start seeing this aggressive pull back in the Fed's funds rate, then we're going to see that bond rally we've been sort of keeping our eye on, waiting for.
For sure. And if we take our eye now to the longer tenor of the interest rate, if you look at the overnight index swap market, the actual average long-term rate currently priced in is roughly around 3.5%, which is materially higher than the long-term neutral rate that the Fed currently forecasts, which is 2.5%. So there seem to be some room for that average long-term rate currently priced in to come down.
And so that's going to contribute positively to longer-term US Treasury bonds. Additionally, term premia currently on those bonds are also at relatively elevated level compared to where we have seen over the past years. So we also think that that is going to be a positive factor contributing to better expected returns of long-term treasury bonds. [AUDIO LOGO]
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