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U.S. CPI data for January came in hotter than expected, causing markets to scale back expectations for when the Fed may start cutting rates. Alexandra Gorewicz, Vice President and Director for Active Fixed Income Portfolio Management at TD Asset Management, discusses why there may have been too much rate cut euphoria in the markets recently.
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* We have more signs that inflation in the United States has not been tamed, with the latest read on consumer prices coming in hotter than expected. So what does it all mean for interest rates and the bond market? Joining us now to discuss, Alex Gorewicz, VP and Director for Active Fixed Income Portfolio Management at TD Asset Management. Alex, welcome back to the show.
* Thanks, Greg. Good to be here.
* You're always here during interesting times. There's a lot to go over, inflation, it just won't-- the expectation is we break below 3. We didn't break below 3. What's going on? Why is it sticky?
* There's no one answer, and that's the sad part. It's actually quite broad based, the stickiness, which is a problem for the Fed. I think if we look at the headline numbers, we had some expected, let's say drags, from goods or energy, although be it less than what was anticipated. And maybe that contributed a bit to the beat.
* But really, it was just core services, even excluding shelter, which is continuing to moderate, albeit at a snail pace. But it's really core services, ex-shelter that's just proving to be quite sticky. Some components actually edged higher, not good.
* I was going to say, we didn't expect that it would be a straight line all the way down from the 8 or 9 where we were way back when down to the 2% target, that there'd be some chop along the way. But is this more than just chop? I mean, are there signs in here that we should be saying, are we going to get to 2? And then the time we think we're going to get there.
* I think it's hard to say at this time. And the reason I say this is it was anticipated by, let's call it inflation experts, really people that are actually putting their money where their mouth is and trading inflation-linked products. It was expected that this month and actually the next couple of months-- so February and March-- are expected to remain call it sticky in that they're not necessarily suggesting inflation across the board is starting to trend higher. But they're sort of stalling the disinflation progress.
* So this, to some extent, was not unanticipated. It was maybe a little bit firmer than that, but nothing that at the moment suggests that the Fed was wrong to pivot. It does reinforce, however, that the euphoria coming into this year with five or six rate cuts to be delivered by the end of the year, it was-- there was just too much euphoria and that that had to give back.
* Let's talk about that euphoria, then, obviously, the fact that we did see Jerome Powell, last time we heard from him, push back against this. Listen, we are not in a rush to cut rates. And the market-- I think there's been a dance. We've been talking about this dance between what the Fed, what our central bank has to say, other central banks, and what the market wants to believe. Are we pulling expectations back in line again, yet again, saying, well, maybe he's serious. Maybe he has reason to wait and be patient.
* Yes, and this definitely reinforced that. But honestly, you didn't need the CPI number to basically validate Powell's stance or, we'll say, the collective Fed's stance that March is too soon because jobs numbers beat. GDP data both, realized for Q4 of last year, as well as advanced data for Q1 of this year-- they're all tracking a lot better than expected, which tells you that the Fed can at least be patient. And this just reinforces that.
* Again, it doesn't necessarily throw off track the disinflation progress. It just stalls it. So we'll see next month and the month after that if we have a genuine pop higher, or if what we've seen today in terms of the broadening of that stickiness in core services-- if that persists over the next couple of months. But in any case, I think the bond market's reaction, which is, OK, we're not pricing in six anymore. Now we're pricing in only four to the end of the year in terms of rate cuts from the Fed. I think that's a lot more appropriate.
* What does it take for the Fed or, really, for the economic data-- I just think in the terms of-- there's been some interesting ideas put out there recently about the idea that, well, if you can have interest rates at this level, which we do consider to be restrictive, more restrictive than they need to be-- they're not at their neutral place. But the economy keeps performing. The labor market holds up. Inflation, obviously, just got a little stuck there above 3-- that the Fed not only doesn't have to be in a rush. Do we have an idea of where rates actually need to be to bring an economy into balance?
That's an excellent question. And I think if we judge based on the reaction that we've seen in interest rates, let's say year to date as this full suite of data-- not just the latest CPI print, but the full suite of economic data-- has been coming in better than expected. I think interest rates have responded accordingly, which is they've edged higher.
* And today, we've had, actually, a pretty significant reaction to the CPI print, as one would expect. 10-year interest rates are higher by almost 10 basis points. Two-year and five-year are up even more than that. So the reaction was somewhat to be expected. But interest rates year to date have actually just been reacting by moving higher just to all of this positive data.
* Where I have more concern for the broader market, both the broader bond market as well as capital market, is that risk assets, whether you look at corporate bonds-- and that's effectively what we say like looking at credit spreads-- or whether you're looking at equities, I think they really ran away with this notion that we'll get five or six rate cuts. And they probably have more adjustment to do after this CPI print than even interest rates. So when I think about where rates are, I'd say they're pretty-- they're pretty fairly priced for only three, maybe four rate cuts that we'll get this year.
* What does it mean for fixed income this year, then? It's still early in the year. I mean, we're only in February. But we had expectations. We're six, seven weeks in, and we're starting to question those expectations. What does it mean for the bond market?
* And we've done this analysis looking back at every rate cut cycle since the '60s or '70s. So we went back a long time. And one thing that we found was that interest rates don't really fall until we're about, let's say, a quarter-- a calendar quarter, so three months-- away from that first rate cut.
* What was clear-- and this is why I keep mentioning the broad suite of economic data-- what was clear from as early as the first week of January is that data was suggesting that the economy is doing better than expected, better than the Fed's forecasting, better than economists are forecasting. And what that meant was that March was too soon-- and we've been talking about that for many months now-- and that June was more likely.
* So if history repeats itself, like it has in prior rate-cutting cycles, that means you will have interest rates come down. And therefore fixed income as an asset class will generate positive returns. But you have to be within striking distance of that first rate cut. I think at this point, it's too far away. As we head into the second quarter, we'll probably see, as long as the data, again, is not suggesting inflation is reaccelerating. As long as the data cooperates, I think that's when you start to see those positive gains in the asset class.
* So with what we know today and, obviously, with the caveat that it can change-- and the data that comes out in the coming weeks and months-- is June still reasonable, a reasonable expectation for the market that perhaps we see that first cut in June?
* Yes. I think so. Interestingly, the bond market's reaction to today's CPI print was to effectively price out any expectation of rate cuts in March. But the May meeting still has a 40% to 45% probability.
* Also, still live. It's still a live meeting.
* Still live. It's still a live meeting. Again, with the data coming in as is-- and it's not just the hard data that I-- some of the data points that I had mentioned. Even looking at survey-based indicators, they're suggesting a little bit of a cyclical upturn, to the extent that that actually translates into economic activity, I think may-- still is too soon. And maybe the Fed can give itself more optionality and start in June.
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* We have more signs that inflation in the United States has not been tamed, with the latest read on consumer prices coming in hotter than expected. So what does it all mean for interest rates and the bond market? Joining us now to discuss, Alex Gorewicz, VP and Director for Active Fixed Income Portfolio Management at TD Asset Management. Alex, welcome back to the show.
* Thanks, Greg. Good to be here.
* You're always here during interesting times. There's a lot to go over, inflation, it just won't-- the expectation is we break below 3. We didn't break below 3. What's going on? Why is it sticky?
* There's no one answer, and that's the sad part. It's actually quite broad based, the stickiness, which is a problem for the Fed. I think if we look at the headline numbers, we had some expected, let's say drags, from goods or energy, although be it less than what was anticipated. And maybe that contributed a bit to the beat.
* But really, it was just core services, even excluding shelter, which is continuing to moderate, albeit at a snail pace. But it's really core services, ex-shelter that's just proving to be quite sticky. Some components actually edged higher, not good.
* I was going to say, we didn't expect that it would be a straight line all the way down from the 8 or 9 where we were way back when down to the 2% target, that there'd be some chop along the way. But is this more than just chop? I mean, are there signs in here that we should be saying, are we going to get to 2? And then the time we think we're going to get there.
* I think it's hard to say at this time. And the reason I say this is it was anticipated by, let's call it inflation experts, really people that are actually putting their money where their mouth is and trading inflation-linked products. It was expected that this month and actually the next couple of months-- so February and March-- are expected to remain call it sticky in that they're not necessarily suggesting inflation across the board is starting to trend higher. But they're sort of stalling the disinflation progress.
* So this, to some extent, was not unanticipated. It was maybe a little bit firmer than that, but nothing that at the moment suggests that the Fed was wrong to pivot. It does reinforce, however, that the euphoria coming into this year with five or six rate cuts to be delivered by the end of the year, it was-- there was just too much euphoria and that that had to give back.
* Let's talk about that euphoria, then, obviously, the fact that we did see Jerome Powell, last time we heard from him, push back against this. Listen, we are not in a rush to cut rates. And the market-- I think there's been a dance. We've been talking about this dance between what the Fed, what our central bank has to say, other central banks, and what the market wants to believe. Are we pulling expectations back in line again, yet again, saying, well, maybe he's serious. Maybe he has reason to wait and be patient.
* Yes, and this definitely reinforced that. But honestly, you didn't need the CPI number to basically validate Powell's stance or, we'll say, the collective Fed's stance that March is too soon because jobs numbers beat. GDP data both, realized for Q4 of last year, as well as advanced data for Q1 of this year-- they're all tracking a lot better than expected, which tells you that the Fed can at least be patient. And this just reinforces that.
* Again, it doesn't necessarily throw off track the disinflation progress. It just stalls it. So we'll see next month and the month after that if we have a genuine pop higher, or if what we've seen today in terms of the broadening of that stickiness in core services-- if that persists over the next couple of months. But in any case, I think the bond market's reaction, which is, OK, we're not pricing in six anymore. Now we're pricing in only four to the end of the year in terms of rate cuts from the Fed. I think that's a lot more appropriate.
* What does it take for the Fed or, really, for the economic data-- I just think in the terms of-- there's been some interesting ideas put out there recently about the idea that, well, if you can have interest rates at this level, which we do consider to be restrictive, more restrictive than they need to be-- they're not at their neutral place. But the economy keeps performing. The labor market holds up. Inflation, obviously, just got a little stuck there above 3-- that the Fed not only doesn't have to be in a rush. Do we have an idea of where rates actually need to be to bring an economy into balance?
That's an excellent question. And I think if we judge based on the reaction that we've seen in interest rates, let's say year to date as this full suite of data-- not just the latest CPI print, but the full suite of economic data-- has been coming in better than expected. I think interest rates have responded accordingly, which is they've edged higher.
* And today, we've had, actually, a pretty significant reaction to the CPI print, as one would expect. 10-year interest rates are higher by almost 10 basis points. Two-year and five-year are up even more than that. So the reaction was somewhat to be expected. But interest rates year to date have actually just been reacting by moving higher just to all of this positive data.
* Where I have more concern for the broader market, both the broader bond market as well as capital market, is that risk assets, whether you look at corporate bonds-- and that's effectively what we say like looking at credit spreads-- or whether you're looking at equities, I think they really ran away with this notion that we'll get five or six rate cuts. And they probably have more adjustment to do after this CPI print than even interest rates. So when I think about where rates are, I'd say they're pretty-- they're pretty fairly priced for only three, maybe four rate cuts that we'll get this year.
* What does it mean for fixed income this year, then? It's still early in the year. I mean, we're only in February. But we had expectations. We're six, seven weeks in, and we're starting to question those expectations. What does it mean for the bond market?
* And we've done this analysis looking back at every rate cut cycle since the '60s or '70s. So we went back a long time. And one thing that we found was that interest rates don't really fall until we're about, let's say, a quarter-- a calendar quarter, so three months-- away from that first rate cut.
* What was clear-- and this is why I keep mentioning the broad suite of economic data-- what was clear from as early as the first week of January is that data was suggesting that the economy is doing better than expected, better than the Fed's forecasting, better than economists are forecasting. And what that meant was that March was too soon-- and we've been talking about that for many months now-- and that June was more likely.
* So if history repeats itself, like it has in prior rate-cutting cycles, that means you will have interest rates come down. And therefore fixed income as an asset class will generate positive returns. But you have to be within striking distance of that first rate cut. I think at this point, it's too far away. As we head into the second quarter, we'll probably see, as long as the data, again, is not suggesting inflation is reaccelerating. As long as the data cooperates, I think that's when you start to see those positive gains in the asset class.
* So with what we know today and, obviously, with the caveat that it can change-- and the data that comes out in the coming weeks and months-- is June still reasonable, a reasonable expectation for the market that perhaps we see that first cut in June?
* Yes. I think so. Interestingly, the bond market's reaction to today's CPI print was to effectively price out any expectation of rate cuts in March. But the May meeting still has a 40% to 45% probability.
* Also, still live. It's still a live meeting.
* Still live. It's still a live meeting. Again, with the data coming in as is-- and it's not just the hard data that I-- some of the data points that I had mentioned. Even looking at survey-based indicators, they're suggesting a little bit of a cyclical upturn, to the extent that that actually translates into economic activity, I think may-- still is too soon. And maybe the Fed can give itself more optionality and start in June.
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