We’re discussing the upcoming July FOMC meeting, ways that investors can approach their short duration assets, and how recent economic data releases have changed the track record of Federal Reserve guidance.
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Yeng Butler: Hello, everybody. I’m Yeng Butler, head of investment solutions and the Liquidity Client Group here at Allspring Global Investments, and you’re listening to On the Trading Desk®. Today, we’re discussing the upcoming July FOMC (Federal Open Market Committee) meeting, ways that investors can approach their short duration assets, and how recent economic data releases have changed the track record of Fed (Federal Reserve) guidance.
Joining us here today are Jeff Weaver, senior portfolio manager and head of Global Liquidity Solutions, and Laurie White, senior portfolio manager for Prime and Government Money Market Funds, who will be providing their insights on this topic. Thank you for both being here, Jeff and Laurie.
Jeff Weaver: Happy to be here, Yeng.
Laurie White: Thanks for having me.
Yeng: So, let’s start at the heart of the matter. The upcoming July FOMC is likely to be yet another important event. I won’t call it a shock, but an important event, in a wave of news that the market has digested in projecting where rates may go. Jeff, can you take us through the most recent data releases and what it might mean for the announcement that’s impending next week?
Jeff: Yes, thanks, Yeng. As we look forward to the July 27 FOMC meeting, where the Fed has generally been expected to raise the fed funds rate by another 75 basis points from the current 1.5% to 1.75% range, it’s important to consider the FOMC dual mandate, that is maximum sustainable employment and price stability.
On the employment front, the June Non-Farm Payroll report, released on July 8, continued to exhibit strength. The economy added a greater than expected 390,000 new jobs and the unemployment rate remained at an ultra-low 3.6%.
With a strong labor market as cover, the Fed is most focused on fighting inflation. And last Wednesday’s Consumer Price Index (CPI) proved how persistent inflation is with a greater-than-expected 9.1%. It’s important to remember that last month, a stronger-than-expected CPI came out the Friday before the June 15 FOMC meeting, which prompted the market to anticipate a 75 basis point rate hike, despite the fact that Fed officials had endorsed and reiterated forward guidance of a 50 basis point rate hike before the blackout period. A Wall Street Journal article subsequently published on Monday June 13 all but confirmed the Fed was considering a 75 basis point rate hike. And that Wednesday, the Fed tightened monetary policy by 75 basis points. That 75 basis point increase was the largest since 1994.
So naturally, with a stronger CPI reading this month, the market immediately began to anticipate a greater than 75 basis point rate hike. In fact, at one point, the fed funds futures market was pricing in an 80% chance of 100 basis point rate hike. This expectation has since come down as a number of Fed officials spoke out against 100 basis point rate hike last week before the blackout period began on Saturday. Even notable inflation hawks, Christopher Waller and James Bullard, both proclaimed that 75 basis points was their base case after the CPI release unless they saw something surprisingly strong in the retail sales or housing reports.
Other Fed rhetoric seemed to indicate that a 75 basis point rate hike is still aggressive, and Fed governors are increasingly concerned that too many rate hikes too fast could push the economy into recession. This view is increasingly being reflected in an inverted yield curve between 2-year notes and 10-year notes.
And additionally, we’ve started to witness weaker bank earnings, headlines for potential layoffs, and already wider credit spreads. So, we do believe that the Fed will follow through with a 75 basis point rate hike on July 27, even though they’ve seemingly left the door cracked open for something larger. One number that caught our attention was Friday’s University of Michigan long term inflation expectations, which decreased from 3.1% to 2.8%. Yesterday, we also saw a new article in The Wall Street Journal by the same reporter that a 75 basis point rate hike was most likely next week.
Yeng: Let me turn to you, Laurie. The majority of markets may react strongly to this July FOMC meeting announcement. But perhaps you can speak to the potential implications specifically for money market fund investors.
Laurie: When we look at the industry data compiled by Crane Data, the average WAMs, or weighted average maturities, on both institutional government and institutional prime funds tells us that portfolio managers have shortened the maturities of their funds, as well as the paper they’re buying in order to take advantage of the upcoming rate hikes. Since yields on money market funds tend to be very highly correlated with the fed funds rate, I would expect to see an immediate increase in money market fund yields the day after the Fed raises rates.
But there is a caveat with that statement. Increases that we see in money market fund yields that day may not fully reflect the size of the rate hike on July 27. That may take a little bit more time, perhaps a matter of days or weeks to work through and price in, because portfolio managers are going to have securities that are going to be maturing and reinvested at higher rates. And they’re also going to have floating rate securities that are going to have their rates adjusted higher, so that will have to work its way through into the money market fund yield. But with positive and rising yields for investors, right now, investing cash and money market funds seems to be a pretty good place to be.
Yeng: Jeff, let me turn back to you. And if we move beyond the realm of money market funds, can you talk about where you’re seeing value further along the curve at this point in time, particularly amidst historic negative returns for short duration markets this year?
Jeff: Yes, Yeng, it is true that cash investors can now rejoice with higher yields. Though the fed funds rate will continue to increase between now and the end of the year, it’s likely that the worst of fixed income returns further out the curve are behind us.
That said, Treasury bill yields continue to trade rich to the expected rate hike path, predominantly because of a lack of supply compared to demand. Meanwhile, 2- and 3-year notes currently offer some of the highest yields on the Treasury yield curve. Each have a yield of approximately 3.16% and they recently traded around 3.5%. At such yields, it’s possible that the 2- and 3-year portion of the yield curve is looking beyond the terminal fed funds rate as it is quite likely that the yield curve becomes increasingly inverted as shorter-term yields increase.
As such, extending out the yield curve could be advantageous for those clients who have carefully considered their potential liquidity needs, particularly if the terminal fed funds rate is reached by the end of the year. While volatility is expected to persist, the market has priced in a lot, particularly when one considers wider corporate spreads, as well.
Yeng: Laurie, back to you. Let’s bring this home. As Jeff mentioned earlier, guidance from the Fed seems to have compressed down from a few weeks’ notice to just a few days. Can you give us your thoughts on where this tightening cycle might end? What are you seeing as the terminal fed funds rate, and what might the path look like along the way?
Laurie Well, those are really good questions, Yeng, and they are some of the questions that the market is pondering right now.
What makes this tightening cycle so different from previous cycles is the degree of the unknowns. When we look back at 2008’s global financial crisis and the tightening cycle that started in 2015, the Fed could really be characterized by one, the deliberate and consistent moves it made. It made 25 basis point moves at each meeting. And number two, the degree to which forward communication around rate expectations were made in order to ensure that smoothly functioning markets persisted. So, it could be fairly easy at that point to conclude when the Fed might finish that cycle.
But this time around, it is really different. The Fed did begin its cycle and in much the same way with a deliberate path. But both inflation and the economy started running very hot. And the Fed seems to be much more data dependent, or rather, their action seems to be more immediate than it has in the past. And we’ve seen, for example, with the last Fed rate hike, that they’ve been able to pivot based on the data that they’ve received at the last minute to be more assertive or aggressive as economic conditions warrant. So, I think it’s fair to say that where the Fed ends this cycle is still in question.
Right now, the fed funds future market is pricing in another 200 basis points in moves between now and the end of the year, which suggests a slightly higher rate trajectory than the Fed itself published with its summary of economic projections in June. So the market is expecting a terminal rate of about 3.5%, whereas the Fed’s dot plot indicated they would be more in the range of about 3 and 3/8%. How did we get there? It could be a combination of moves. Market data suggests at this point that we would start with the move of 75 basis points in July, followed by September and November at 50 basis points and another 25 basis points in December. And believe it or not, the market is actually pricing in that the Fed might ease starting in March after waiting to see what the effects are for a few months.
So, I guess the question really is is do we think that that terminal rate is accurate or that the timeframe is realistic? And it could be that the terminal rate the market is expecting might be a bit low and that the timeframe might be a bit premature. And the reason I bring that up is there are two things that we know about this Fed. They are determined to bring inflation to heel. And number two, they will want to see concrete results that inflation is receding before they take their foot off the brake. So that might argue for them to overshoot. And by that, I mean, it might argue for them to take rates a little bit higher for a little bit longer than what the market is expecting in order to ensure that inflation is really tamed.
Yeng: Thanks, Laurie. Well, I’m sure there will be plenty to talk about between now and then and when these things actually take place. Nevertheless, I think it’s always important to share with our clients where we might be headed, and hence, how to best prepare for those expectations. So now with the time we have left, can you perhaps both share a parting thought for our listeners? Let’s start with you, Laurie.
Laurie: Sure. Yeah, you bring up a good point. There’s going to be a lot going on. And the next meeting after July is going to be in September on the 21st. Then there’s going to be a lot of data coming out between now and then. I think it behooves us as investors to keep an eye on the data. We know the Fed is going to be keeping an eye on it. And then starting in September, we’re going to have three more meetings before the end of the year. So, we should all be prepared for a very eventful fourth quarter.
Yeng: Thanks, Laurie. And how about you, Jeff?
Jeff: Yes, I think in its fight to contain and bring inflation under control, the Fed is playing a tricky game. It will be very difficult for them to execute a soft landing where rates have been raised so aggressively enough to fight inflation, but not so much that it slows growth to the point of recession. Rate hikes take some time to take hold and ultimately, the effect of aggressive rate hikes looking at next year are tough to handicap, at this point. As mentioned earlier, the fed funds market is already pricing in rate decreases in 2023, and the yield curve is becoming more inverted. In the meantime, however, money fund investors can look forward to higher short-term rates and can evaluate opportunities to extend.
Yeng: I really appreciate you both being with us today, Laurie, and Jeff, and for sharing your commentary with our listeners.
Jeff: It was a pleasure. Thank you.
Laurie: My pleasure. Thank you for having me.
Yeng: That wraps up this episode of On the Trading Desk. If you’d like to read more market insights and investment perspectives from Allspring Global Investments, you can find them at our firm’s website, allspringglobal.com.
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100 basis points equals 1.00%. The Consumer Price Index (CPI) is a measure of the average change over time and the prices paid by urban consumers for a market basket of consumer goods and services. You cannot invest directly in an index.
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