By Serafino Tobia, Director of Agency CMBS Trading and Portfolio, Greystone
“The time has come for policy to adjust” – Fed Chairman Powell, Federal Reserve Symposium Jackson Hole, WY, Friday 8/23/2024
US Treasuries
The 10-year Treasury yield is at 3.80% as of August 26, seven basis points lower than the closing level on August 19. Yields have come a long way – for context, the 10-year rate posted a recent high-mark on May 29 at 4.61% and traded in a 30-basis point range (4.16% - 4.46%) in June and July. Three weeks ago, after the July unemployment rate printed at 4.3% (a 0.2% increase from June), the capital markets focused on recession fears; 10-year yields traded as low as 3.66% intraday on August 5. At the time, Wall Street economists made the point that July’s 2/10th percent increase in the unemployment rate triggered the Sahm Rule which would indicate that we are now approaching a recession. Some securities dealers called on the Fed to have an emergency meeting to start reducing the Fed Funds rate by a half point (which went unheeded by the Fed). Over the past three weeks, concerns over an imminent recession have receded, yields moved off their lows and have been trading in a 25-basis points range (3.76% - 4%).
Fed Monetary Policy - Full Pivot
Fed Chairman Powell’s comments on August 23 at the Federal Reserve’s annual retreat in Jackson Hole, Wyoming were unequivocally dovish: "The time has come for policy to adjust…the direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks."
As you know, for just over a year now, the Federal Reserve has pegged the Fed Funds rate to a restrictive 5.25% - 5.50% range with a focus to reduce the rate of inflation. Going forward, the Fed will de-emphasize its focus on inflation and move towards its other mandate – full employment. The Fed will likely start moving the Fed Funds rate lower by 0.25% - 0.50% at the next FOMC meeting on September 18. Before the September FOMC meeting, we will see the August print of the US Employment Report on September 6, and at this point Wall Street economists are expecting a marginal improvement with jobs, 155,000 new jobs and 4.2% unemployment rate (versus just 114,000 new jobs and 4.3% unemployment rate in July). It is likely that a ½ point cut in the Fed Funds is too optimistic at this juncture, but we shall see how the employment numbers look.
Is Now a Good Time to Rate Lock?
With 10-year Treasuries at 3.80% +/-, we are back at the low-end of the range since the beginning of the year. Yes, the Fed has indicated it is about to start cutting interest rates, but that’s only the overnight Fed Funds rate and not the entire yield curve; the yields on 2-, 5-, 10- and 30-year bonds are determined primarily by expected inflation and supply and demand. The bond market is already building-in substantial Fed rate cuts; the yield curve implies that the Fed will lower the Fed Funds rate by 1% by year-end 2024 (down to 4.35% from about 5.35%) and then another 1.25% in rate cuts by year-end 2025 (down to 3.10%). That sounds optimistic to me; the bond market may be overestimating how the economy unfolds, the likelihood of further improvement with inflation and what the Fed will do.
To my thinking, interest rate risk on the long end of the curve is asymmetrical at this juncture. The possible increment for a further reduction in longer interest rates is less than the chances that rates move back to 4% or above. We may well see 10-year rates move another increment lower to around 3.50% +/-. However, easier monetary conditions are inflationary, meaning inflation could re-ignite some which would limit further rate improvement. Fundamentally, if you think inflation moves down to 2% +/-, that implies a 10-year Treasury yield at around 3.50% - 3.75% (considering a real return on investment and an add-on for term risk). If inflation stays sticky at around 2.50%, 10-year rates should be around 4%. We could see inflation and long interest rates move back higher.
The caveat is that we may well be at the start of a recession. That’s not how I see it, but clearly the 2/10ths increase in the unemployment rate last month is concerning. If the unemployment rate continues to increase, that would provide more room for interest rates to move lower.
Separate Note – On August 21, 10-year yields traded down to 3.76% after the Bureau of Labor Statistics announced that job growth was 818,000 less than initially reported for the 12-month period ending March 2024. Annual revisions are typically +/- 0.1%; this was a -0.5% revision, 5x the average. Rather than 2.9 million new jobs for this 12-month period, the job growth was only 2.1 million. Said another way, instead of monthly job growth of 246,000 on average, new jobs grew at a 178,000 monthly pace; significantly slower. The market has since discounted the significance of the revision but in the context of a possible impeding recession it’s worth noting that the labor market wasn’t as robust last year as we had been told.
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