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TCW is a leading global asset management firm with over 50 years of investment experience and a broad range of products across fixed income, equities, emerging markets, and alternative investments. In each episode of TCW Investment Perspectives, professionals from the firm share their insights on global trends and events impacting markets and the investment landscape.
In just the last few weeks, we've seen consistently weaker economic data and
a dramatic shift in interest rates and the market's expectations for the Fed.
Even so, there's plenty of uncertainty about the outcome of the Fed meeting
later this month and the future path of interest rate cuts, not to mention
the looming specter of a presidential election coming up in November.
In this episode, we'll explain why the September 17th meeting isn't just
about interest rate cuts, but the broader perspective on the economy,
growth, and how those compare to past Fed easing cycles and recessions.
We'll also look at what history tells us about
where rates and the economy are headed next.
Welcome to Focus on Fixed Income, the TCW Investment Insights podcast.
I'm David Vick, joined by our Global Rates
co-heads, Jamie Patton and Bret Barker.
So with that, let's get started.
First, let's start with the obvious.
What have we seen in the data over the last few weeks?
And maybe more importantly, what's been the market reaction to that data?
The data has been markedly weaker, especially
the labor market over the past couple of months.
Last week's employment report maybe lacked a definitive answer
around whether the Fed will go 25 basis points or 50 basis points,
but it confirmed the trend, which is labor market weakening.
I say that because the revisions implied a three-month
moving average rate of job gains at $116,000.
This is well below what we call the break-even payroll rate.
And what I mean by that is the rate at which unemployment will not rise.
There are a range of estimates as to what that number is,
depending on how much you think immigration is adding right now.
But even the low end of that wide range is higher than $116K.
Jolts also showed further deterioration in the labor market.
Job openings continue to trend down and the ratio of job
openings to unemployed dropped to below pre-pandemic levels.
As a result, the market reacted in a big way.
Since July 1st, the front end had rallied over 100 basis points.
Two-year yields are the lowest they've been since 2022.
And the curve, specifically two-year, 10-year,
disinverted for the first time since 2022.
We got another two or three more Fed rate cuts priced in this year.
And we also got another 125 basis points of rate
cuts, additional rate cuts priced in for next year.
So terminal rates, what the market is implying for Fed policy rates in the
future, the bottom of that curve went from nearly 4% to the mid-high 2%, meaning
that instead of ending the rate cutting cycle around 4%, the Fed's going to cut
rates all the way down to the mid-high 2% according to the forward rates market.
I think those are great points.
I think that what stands out to me, I think, is when you
mentioned is the un-inverting of the treasury curve.
When we look at twos, tens, that's been
inverted for the better part of two years here.
And I think that when you see this kind of un-inversion, I
hate that term, but that's kind of how we're using it here.
But it's very different when you think of fall of last year.
The curve is steepening, but that was a talk about term premium, right?
And 10-year rates are going to 5%.
That's not the case right now.
This is a bull steepening, as we call it on the desk here,
is where it's being led by the front of Fed expectations
that two years are rallying more than the 10-year.
And that's usually when we see these turn in the cycle.
So that's kind of a big indicator for us that you're seeing
the shift in the regime that the easing cycle is beginning.
So we talked about the labor market, which is obviously critical.
What about the inflation data?
Where has that come in lately?
What are we seeing on that front?
Yeah, I think that, you know, for the Fed,
they'd like to focus on the super core PC.
So it's taking out, you know, food, energy, and the service sector.
And what you're seeing there is a material slowdown there as well.
I think the month of month gains are around 0.2% month over month.
And the year over year is at three and a quarter.
Now that was 2% pre-pandemic obviously, but
it was 4% to 5%, you know, not too long ago.
So it's all going in the right place.
And I think Powell's comments at Jackson Hole were very
clear that they feel more confident on the inflation front.
So I think when you combine what Jamie's seeing and note in the labor
market with that kind of deteriorating slowly, it's called weakening.
And if you see inflation coming close to the target, more confident, it
does look like 5.5% for Fed funds is probably the wrong level for Fed.
That's not neutral.
So for us, I think it kind of goes to the, I think the market pricing we talked
about earlier too, Jamie mentioned how aggressive it's been is maybe we should
take a step back and say the market in the early part of spring or late spring,
early summer was looking at, you know, basically just one cup for the year.
So the market was almost expecting this kind of Goldilocks higher
for longer to quell inflation and equity markets were very buoyant.
And fast forward two months now, the labor market is, you know, at 4.2% already
above the Fed's projections for this year and inflation is on its way down.
So that supports the view of rate cuts.
Great.
Jamie, you talked a little bit about market expectations for rate cuts.
Obviously September's coming up here in a couple of weeks.
What are we thinking?
25, 50, maybe doesn't matter a ton.
Like what are we thinking about the path of the Fed and not only
in September, but also kind of in meetings subsequent to that?
The market is currently pricing in about a 30% chance of a 50
bit break cut with a hundred percent chance of at least 25.
What was interesting to us is that after the week payroll print on
Friday, we heard from both Fed presidents, Williams and Waller.
Waller said he would back a 50 basis point rate cut if justified by the data.
But his upbeat view of the economy suggested that he's going
to stay in the 25 basis point camp until proven otherwise.
And then New York Fed president Williams, he's normally leaning pretty dovish.
He hasn't really made an effort to prepare
the market for a 50 basis point rate cut.
And now the Fed is in their blackout period.
So it would really take a message through the Fed mole Nick Timmerall
or something like that for the market to change its mind and
come to expect a 50 basis point rate cut at the next meeting.
That said, to your earlier question, absolutely right.
We just don't think it matters.
25 basis points, 50 basis points, whether the Fed is incredibly restrictive
or just a tiny bit less than incredibly restrictive really doesn't matter.
We saw really long lags between the Fed's monetary policy
adjustments and the impact to the market on the way up.
And there's no reason that it would be any different on the way down.
This means the economy is going to take longer
to feel the loosening of Fed policy rate cuts.
So here are some examples and why I say that.
Now, we all know that the Fed raised rates by over 5%.
Yet the effective rate on mortgages outstanding
has only risen around 60 basis points.
So we were around 330 at the low of the weighted
average coupon on effective coupon on mortgage rates.
And this has only gone up.
It's not even at 4% yet.
So it's risen just about 60 basis points, even
though the Fed has raised rates by 500 basis points.
Compare this to other global economies that are more interest rate sensitive
with shorter lags than the US, Canada, New Zealand, Australia, Norway, Sweden.
They're all mostly floating rate mortgages.
So take New Zealand, for example.
New Zealand effective mortgage rates are over 3% higher in the time that
their central bank raised rates exactly the same amount as the Fed.
So they went from three, three and a half up to six and
a half percent, while in the US we went 60 basis points.
They went to six and a half percent.
Some other stats just to illustrate how little the Fed
policy is actually feeding into markets and the economy.
We have an $8 trillion agency mortgage market.
Only 6% of mortgages outstanding are floating rate.
This was 35% before the global financial crisis.
So we're talking about a totally different market than pre-2008.
In the Bloomberg Aggregate Mortgage Index, 85% of the 30-year fixed rate
conventional mortgages do not even begin to become economic to refinance
until 10-year rates are over 100 basis points lower from here.
So we're not even really close to the economy feeling easing, even
if the Fed goes, even if they go 75 in September, which they won't.
Just some other stats.
One in three home purchases are made with cash today.
So 40% of homeowners own their houses free and clear.
They don't even have a mortgage.
So it's even less likely that they're going to feel any
easing when the, when the Fed policy rate comes down.
So it sounds like to me, you're saying that the, the Fed can
cut rates and it's not going to make a ton of difference.
So if we're headed for a hard landing, what the Fed does over
the next couple months probably doesn't change that too much.
Is that the correct interpretation of that?
That's correct.
I'd probably say that maybe everyone's making a lot about the September
meeting and yes, it is the first, the first cut in this easing cycle.
But if in fact the labor market is weakening as many
fear, there probably might be behind the curve already.
That's the problem here is, and they won't know until it's too late.
And to Jamie's point, you know, to stimulate the economy, if
you're cutting 50 basis points called the beginning of next
year, that won't impact the economy until later in 25, early 26.
So again, I think it's kind of the same old
rule here that if it overstays, it's welcome.
Maybe if it's too late to raise rates, obviously when inflation was rising and
they're probably going to hold on to rates too long here and for too high,
you know, too high for too long and then they'll have to cut aggressively.
And to Bret's point, when you think about all the things
that have to go wrong for that unemployment rate to rise.
So the employer who just worked so hard to fill that spot
in 2020 when it was impossible to hire, it's the last
thing that they want to do is lay off that worker.
So all of the things that have to go wrong have already
happened by the time you see the unemployment rate rise.
And to Bret's point, that's why it's easy to see the Fed behind
the curve if they're waiting for these really lagging indicators.
Okay, so Jamie, you mentioned that 75, they weren't going to do that,
but is there a number where they could cut to make a difference?
And if there is that number, how fast, how fast they
have to get there and could they get there all at once?
It's a really good question and it's easy to criticize the
Fed, but the reality is that they have such a tough job.
They're stuck between a rock and a hard place.
In reality, they need to cut rates really aggressively and
really fast so that they don't end up behind the curve.
But the data just doesn't justify it quite yet because the data is so lagged.
So if they were to cut a substantial amount, over a hundred basis
points in September, yes, the market would react, but the market
would freak out and wonder what does the Fed know that we don't.
So it's a really tough position that the Fed's in, basing their decisions off
of data that's going to be lagged, then their decisions are going to be lagged.
And they're almost definitionally behind the curve.
I think for us, it's really not a matter of if they go 25 or 50 in September.
It's kind of when we talk on the desk, when Jay and I discuss
what is the end game and it's going to be probably low 2% for
Fed funds and it's really going to be about the pace for it.
I mean, if you look at what's priced in now, it's roughly
what 10 cuts by the end of next year, like roughly 18 months.
The probability of it playing out in that kind of
gradual fashion is probably pretty low in our minds.
It might cut slowly here, but then as the labor market turns
and inflation is where it needs to be, they're going to realize
they are behind the curve and have to cut more aggressively.
And so that pace will speed up tremendously.
And so we think that's just kind of where we're viewing it is that
let's focus on the end game, the finish line at like a low 2%.
Got it.
How far do we think the Fed goes?
Like how many times are they going to have to ease?
I know it's a loaded question.
You can't know for sure, but like how many times and how
fast, like relative to markets maybe, or just outright
levels, what do you guys think where they end up?
I love the opportunity to look ridiculous in the future.
So I'll take a crack at it first.
Bret knows exactly where they'll end up.
Yeah, exactly.
So I would think, you know, for us, you could say a fundamental
fair value for us is probably two and a half percent
of Fed funds, two and a quarter, two and a half.
We don't think you're going back to the zero bound.
That's probably the biggest point for us.
But just as the Fed overshot probably the way
up, we expect them to overshoot on the way down.
I think when you start seeing the Fed cutting rates and they're not seeing the
desired impact from those rate cuts, we would think you go through neutral.
So you could see a Fed funds at two percent or below.
The Fed's own definition of neutral is two and a
half percent as defined by their long-term dot.
There's a lot of speculation around should that be higher?
Is our start higher?
We never really know until it's in the rear view mirror.
But just taking the Fed's own dot at two and a half percent,
even if it's too low by 50 basis points, let's say the long-term
neutral is three percent, just being really conservative.
The market has only priced that in for terminal rates.
So that means that the Fed can raise rates by over 500
basis points, keep it there for years and years, and then
just come right back down to neutral, no harm, no foul.
We think that that is absolutely a fairy tale.
The Fed's going to have to go below their neutral rate and
become easy again to get the economy started up again.
All right.
Makes sense.
So in this world, we have obviously lots of uncertainty about the Fed.
Of course, we also have a presidential election coming up in November.
How does that impact either the Fed or markets?
Or what do you see going forward in the impact of the presidential election?
The Fed will tell you that it absolutely does not impact their decisions.
There's a lot of people who don't believe it when
the Fed says it, but we take them at their word.
We think that they are basing their decisions off
of the data, which is not necessarily perfect.
It's super lagged.
But we don't think that the elections play into the Fed's decision.
At least it shouldn't.
It's not supposed to.
And as for the presidential election itself, while the composition of spending
and taxes would be so different depending on which candidate wins, we actually
think that the outcome of the election is less relevant
than whether there's a wave, a blue wave or a red wave.
Either wave, we think, would increase the
budget and spending in this treasury issuance.
That historically has not led to any higher rates.
Historically, the amount of treasury issuance and
the absolute level of rates is totally uncorrelated.
But what it does result in is higher term premium and a steeper curve.
So it gives us even greater conviction in our steeper curve view.
Great.
Well, thanks very much, guys.
Appreciate it.
And that's it for this edition of TCW's Focused on Fixed Income podcast.
I want to thank our guests, Jamie Patton and Bret Barker,
for their insights and our listeners for tuning in.
Be sure to join us every two weeks for more expert analysis and
in-depth conversations on the trends shaping the fixed income markets.
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