Monetary Policy – Growth and Inflation Setup

The Fed Funds futures market is currently expecting the start of a prolonged rate-cutting cycle beginning next month. While the highest probability points toward a Fed rate cut at the September meeting, the outlook for continuous rate cuts by the magnitude the market currently expects appears less certain. To map this, out we can look at the current implied rate changes with a growth and inflation base effect overlay.

Looking at implied rate changes through 2025, we can start with the lows seen last December (the orange line) when the market expected 126 basis points of rate cuts over the nine months into the September 2024 meeting. Seven months later (the light blue line), no rate cuts occurred and expectations for rate cuts by September were much lower at 17 basis points. At the close yesterday (the black line), 33 basis points were priced in for September, followed by roughly 30 basis points of rate cuts at each meeting through March 2025.

Source: Bloomberg.

Turning to the macro backdrop, two of the key reasons (in addition to the labor market) we believe the market may once again be ahead of itself are due to the likely path of growth and inflation as we move through the fourth quarter and into 2025.

1. 1. GDP growth will likely not drop off to a point that would justify the current level of rate cuts priced in. If GDP increases q/q by the twenty-year average for third quarters, the y/y growth rate will slow from 3.1% to 2.7% in 3Q24, not a growth rate consistent with prior rate cutting environments. If GDP declines q/q by the lowest third quarter print from the last twenty years (3Q08), the y/y growth rate will slow from 3.1% to 1.5% in 3Q24, not a fantastic print, but one that would have pointed toward resilience just over a year ago. Looking further out to Q4 using the same analysis, if GDP increases q/q at an average Q4 pace the y/y growth rate will slow to 2.4%. If we match the twenty-year Q4 low (4Q08), the y/y growth rate will slow to -1.0%. Given the trends in the latest economic data, the highest probability outcome for the next two quarters does not line up with matching 2008 levels but is more in line with matching average growth rates.

   

   Source: Macrobond.

   2. Inflation continues to be above the Fed’s target level and has a rising probability of accelerating in the fourth quarter and into 2025. At 2.9% as of July, headline CPI has been above target for forty-one consecutive months. The largest changes in contribution over that stretch have come from the downshift in Oil prices and slight easing of Housing prices. In August and September, the comparison set for Oil remains tough, meaning we could continue to see slower y/y growth rates in the next two months. That dynamic reverses in the back half of the fourth quarter as Oil moved from $89/bbl to $72/bbl from the end of September into the middle of December last year, therefore staying around $75/bbl to $80/bbl would likely lead to higher y/y contributions to CPI in that period. To add to that inflationary setup, the lag in home prices will likely make its way into the Housing component of CPI in the fourth quarter and carry into 2025. This can be seen in the relationship between S&P Case-Shiller Home Prices and Owners’ Equivalent Rent, as the former tends to lag the latter by twelve to fifteen months. One of the key takeaways here is that if Housing stays close to 1.9 on the contribution front, the other two-thirds of CPI has been contributing more than a full percentage point in ten of the last twelve months. Either the Housing contribution must fall at a faster pace, which is unlikely, or the other two thirds must start subtracting from headline growth to reach and maintain the Fed’s 2% target.

Source: Macrobond.

On the market side, the risk in positioning for the number and magnitude of rate cuts the market currently expects can be observed in yield movements in the eight months from October 2023 through May 2024. From October into the end of 2023, 10-year and 2-year Treasury yields drifted lower on rising expectations for rate cuts. As the outlook shifted and expectations for rate cuts were pushed out, yields drifted higher into May. Today, the 10-year is around the same level seen last December as expectations for rate cuts have increased once again.

Source: Koyfin.

While growth may slow into year-end, the current setup does not suggest it will hit recessionary levels. Additionally, inflation is still running above the Fed’s target and the comparison set likely tilts the range of probabilities toward a reacceleration in 2025. Given that backdrop, the pace and magnitude of rate cuts currently expected does not seem justified. As the September 18^th meeting draws closer, we will continue to monitor incoming economic indicators and market-based signals for the likely trajectory of interest rates beyond the third quarter and into 2025.

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.  The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.