Until recently, the prevailing market narrative since October was that the Fed was in a “pivot” to eventual rate cuts given a Goldilocks economic environment defined by falling inflation and a moderate economic expansion. Last week’s data readings and the market’s reaction indicate that US economic growth may be moving out of a “soft landing” zone into a deeper contraction. The focus on growth preservation rather than inflation fighting should serve as a tailwind for fixed income, leading to lower yields and a return to a negative correlation with equities.
On Thursday, the manufacturing PMI survey and its employment component shifted further into contraction territory, spooking investors. While the indicator hasn’t been a focus for markets (it’s been sub-50 for over a year), the reaction to the print demonstrates the market’s sensitivity to a growth slowdown.
July’s employment figures also triggered concerns. Nonfarm payrolls expanded by 114K, which was below consensus expectations, sparking fears of a deeper slowdown and a higher probability of a near-term recession. The composition of the report was soft all around, with most jobs coming from the non-cyclical healthcare sector, and the unemployment rate increasing to 4.3%.
The focus for investors has shifted to the Fed’s preservation of the strongest pillar of the US economy: the labor market. In this regime, negative surprises to the labor market and economic growth data will result in lower bond yields, as markets price in the Fed being too slow to fight unemployment, while risk assets fall and credit spreads widen. Instead of moving in tandem, like we saw during the Fed’s “on hold” period, bonds will move inversely to risk assets in a classic “fight to quality” fashion. This happened last week after the negative data surprises: 2-year yields fell by 53 basis points and 10-year Treasury yields fell by 38 basis points. Corporate credit spreads experienced their first material widening event of the year, with investment grade spreads widening by 12 basis points on the week, and high yield spreads rising by 51 basis points.
Volatility continued to pick up over the weekend in Asian markets, and Monday’s US session started off with a rush to quality, which is spurring calls for an emergency Fed easing before its next meeting in September. We believe an intra-meeting rate cut is unlikely as it will accelerate rather than mitigate current market stress. The Fed risks sending a signal that underlying economic conditions are much worse than they are.
In past Notes from the Desk pieces, we’ve written about the asymmetric nature of yield outcomes being skewed to the downside as yields had ample room to move lower since a clear disinflation trend ruled out additional rate hikes. To that end, a higher probability of recession means yields could shift lower if data continues to disappoint to the downside. The markets are now pricing in a more aggressive Fed easing, with 125 basis points of cuts for 2024 (with three meetings left), and a terminal rate of 3% in late 2025. Prior easing cycles have averaged 285 basis points of interest rate cuts, so markets have shifted from a soft landing closer to an average recessionary outcome.
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