From PGIM Fixed Income Chief U.S. Economist, Tom Porcelli
In one of the more anticipated FOMC meetings in recent memory, the Federal Reserve kicked its easing cycle off with a 50 bp rate cut. While it was the subject of much debate, the size of the reduction is secondary. More importantly, it marks the recalibration of U.S. monetary policy to an environment of lower inflation and steadily moderating growth.
The mixed message of a larger cut now, with two 25 bp cuts expected through the remainder of the year, elicited a subdued market reaction with the U.S. yield curve continuing to slightly steepen.
Although the Fed clearly laid out its easing expectations for the remainder of the year, it’s possible that further weakening in the labor market—as well as the knock-on effects into retail spending—could challenge the view of a more moderate easing trajectory. However, the Fed has clearly indicated that it will shift policy as needed with the incoming data.
While the decision to cut by 50 bps was close—the distribution of the “dot plot” was almost evenly split—the parity belies what may be a straight-forward reaction function.
If payrolls keep coming in soft, the argument for going with larger cuts will be apparent to the other half of the distribution—and the opposite will be true. The calculus may be that simple for this Fed.
The kickstart to the Fed’s easing cycle turns the focus to the perceived neutral rate and the time horizon needed to get there. Much as we anticipated, the Fed also anticipates another 100 bps of cuts through 2025. This indicates that front-loading cuts may enable a more moderate easing pace with the Fed funds rate projected to reach a terminal level of 2.9% by early 2026. However, we believe the Fed may arrive at its terminal rate sooner than it currently projects based on the incoming data. At this point, the market is pricing in arrival at the terminal rate by September 2025.
In sum, a policy shift that arrives at neutral sooner may be warranted to extend the current cycle of economic growth.
The Time Has Come
U.S. fixed income markets exhibited a relatively muted reaction to the historically-large rate cut. Chairman Powell clearly communicated the Fed’s recalibration strategy for returning policy rates from restrictive territory to neutral. Consequently, outright Treasury yields oscillated within local ranges and the long end cheapened by 5 bps. Today’s Fed action strengthened the larger macro theme of steeper global yield curves, which was further reinforced by the Fed’s latest Summary of Economic Projections.
Also read: What Happens When Interest Rates Change?
As previously mentioned, the Fed lowered expectations for policy rates by 75 bps for each of the next two years and expects to approach its long-term target rate by the end of 2026. As economic data have deteriorated, forward market rates have rallied more than 150 bps since June. If the Fed achieves its projected glide path, these long-dated forwards seem reasonably priced.
Overall, risk assets closed roughly unchanged despite intra-day volatility. The larger impact was witnessed across volatility markets as shorter-dated swaptions cheapened, indicating anticipation of relative calm ahead. As the Fed has clearly communicated, the size and scope of further accommodation will be dictated by incoming economic data. Should inflation or employment data deviate from recent trends, expectations for both forward rates and volatility may also need to be recalibrated.
From Joshua Rout, CFA, Portfolio Manager, Franklin Templeton Fixed Income
The Fed is clearly shifting its focus to the labour market.
They’re much less worried about upside risks to inflation and I think that stems from the labour market being in much better balance and no longer triggering excess inflation across core services items.
With the first cut now behind us, The Fed’s median projection is for only a modest further increase in the unemployment rate to 4.4%.
In contrast, many of the most widely followed leading indicators of the unemployment rate are continuing to deteriorate. This suggests to us the Fed will lower rates quickly and perhaps even faster than what’s currently priced by the market.
Upcoming labour market data will be the most critical determinant of the pace of rate cuts over the coming months.
The broader backdrop of China’s growth underwhelming and commodity prices falling gives the Fed a green light to ease aggressively if the unemployment rate rises more than expected.
