By Brian Johnson, Director of Investment Services

Markets are Sensing a Change in the Air

As summer gives way to fall, markets are also sensing a change in the air. The transition into a new season mirrors the shifting tone in economic data…where cooling employment, moderating growth, and a potentially more dovish stance from the Federal Reserve’s Federal Open Market Committee (FOMC) are reshaping expectations in fixed income markets.

The FOMC’s dual mandate focuses their attention on maximum employment and price stability. Over the past few months, there have been signs of slowing in the employment market. That slowing trend was reflected in the August non-farm payroll number that showed just 22,000 new jobs created during the month, down from 73,000 created in July.

The Bureau of Labor Statistics’ August report also reflected a revision to the June employment numbers, showing a loss of 13,000 jobs for the month. The job loss in June marks the first time the U.S. economy lost jobs on a net basis since December of 2020. As a result of the slowdown in job creation, the unemployment rate ticked up to 4.3% for the month of August.

With respect to the other side of the Fed’s dual mandate, inflation in the U.S. remains sticky. August’s Consumer Price Index (CPI) report showed headline inflation coming in at 2.9%, up from a 2.7% increase in July. Core inflation for August (excluding food and energy) was also up for the month, coming in at a seasonally adjusted 3.1%.

The FOMC’s preferred measure of inflation, the Personal Consumption Expenditures (PCE) index, increased at annualized rate of 2.6% in July. Although inflation metrics are down significantly from their peak roughly 3 years ago, they are still hovering above the FOMC’s preferred target of 2%.

With a softening job market and persistent inflation, even if at nominal levels, Americans’ confidence in the economy appears to be waning as well. The University of Michigan’s Consumer Confidence Survey published its preliminary results for September and the survey’s confidence index showed a decline to 55.4 in August from 58.2 the prior month and representing the lowest reading since May (a reading over 50 is still considered “above average”). Regarding the results, Joanne Hsu, the Director of the University of Michigan’s Consumer Confidence Survey stated “consumers continue to note multiple vulnerabilities in the economy, with rising risks to business conditions, labor markets, and inflation. Likewise, consumers perceive risks to their pocketbooks as well.”

Despite recent slowing in employment and consumer confidence, growth in second-quarter gross domestic product (GDP) was revised up to 3.3%, driven largely by consumer spending and a drop in overall imports, which subtract from GDP growth. Second quarter GDP growth also showed a nice rebound from the modest contraction during the first quarter of the year. While recent data releases point to risks for continued growth, the second quarter reading highlights the resiliency of the U.S. economy.

Facing a difficult task to support the labor market while not allowing inflation to creep higher, the FOMC cut their benchmark rate by 25 basis points (0.25%) at their most recent meeting held September 16-17. Following the meeting, Jerome Powell stated, “the marked slowing in both the supply of and demand for workers is unusual in this less dynamic and somewhat softer labor market. The downside risks to employment appear to have risen.”

Per the CME’s FedWatch tool, the market is pricing in an 88% probability of a quarter-point cut at the FOMC’s October meeting (up from 48% one month ago) and an 80% probability of another quarter-point cut in December (up from 36% one month ago).

As the FOMC balances their priorities in setting monetary policy for the remainder of the year, they will have several key points to consider. If they lean too hawkish (i.e. maintain the federal funds rate at its current level), there is risk of accelerating labor market weakness, rising unemployment, and possibly a drop in consumer spending/confidence. If they lean too dovish (cut the federal funds rate aggressively), inflation might reaccelerate which could also lead to a drop in consumer confidence.

Looking beyond cash and overnight rates that largely track the fed funds rate and near-term expectations of its movement, we’ve seen short and intermediate-term yields decline across the board as well, with heightened market expectations for further FOMC rate cuts. As of the writing of this article, the 2-year, 5-year, and 10-year U.S. Treasury were down approximately 40 basis points where they respectively closed in early June.

With the potential for continued yield curve steepening, targeting a long-term investment strategy is a great way to build cash flow stability for your entity’s operating needs in today’s marketplace and for years to come. Even though it might seem counterintuitive to buy a lower yielding security than what you can receive in a liquid, overnight rate, stability in cash flows and predictable income can pay dividends over budget cycles when it comes to your investment strategy. If the FOMC follows market expectations, overnight rates could be more than 1.00% lower by this time next year.  For every $1 million in investable assets, that’s $10,000 of income.  The “cost” of immediate opportunity is the expense paid for certainty and stability in your revenue budget in the coming years.  A balance approach is warranted at these inflection points.

If you’re interested in discussing your current or even different portfolio strategies, please contact your Ehlers Investment Adviser.

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