Here we go again

It should be no surprise when the financial markets get ahead of themselves. And we don’t need to be an expert at behavioral economics to know rational investors don’t exist. But that doesn’t make it any less frustrating when traders get over their skis, adding volatility and detracting from liquidity in the market. Just as they did late last year, markets are betting the Federal Reserve cuts rates faster than policymakers have indicated and, importantly, faster than the data is supporting. 

Provoked by the Labor Department’s substantial downward revision of jobs added this past year and Chair Jerome Powell’s dovish comments at the Federal Reserve’s central bank symposium at Jackson Hole, Wyo., the futures market has increased the odds of a 50-basis point cut in September policy-setting meeting. We don’t agree, expecting a quarter-point reduction. The air is thinner near the Grand Tetons, but it’s the markets that seem to be affected by the altitude.

Case in point is that downgrade of the employment figure. The Dept. said that the economy added 818,000 fewer jobs over the past 12 months through March than it had reported. Because that is the largest downward revision since 2009, investors seem to be treating it as the mark of an imminent recession. But we have always felt the Fed is comfortable with monthly additions of around 150,000 jobs as it describes an economy growing at a reasonable pace. Well, the new average is 174,000—not as “red hot” as before the revision, but with a robustness still indicative of a soft landing.

While monetary policy works with a lag, the Fed likely views the labor market as supporting a soft landing, not a free fall. Like all policymakers, Powell engages in FedSpeak. But I’ve noticed over his tenure that when he says something clever or creative, it seems to represent his true thoughts. His address in Jackson Hole included this odd turn of phrase: “We do not seek or welcome further cooling in labor market conditions.” He is not panicking. In our minds, it would take an extraordinarily weak August payroll number combined with a large jump in the unemployment rate to shift our expectations from a quarter-point to a half-point cut at the September FOMC meeting. On the flip side, the data would have to be very strong to derail the Fed from easing at all. Inflation prints between now and then also are key, of course. Policymakers will have seen all three major government reports—July PCE and August CPI/PPI—before they meet Sept. 16-18, and the same logic applies.

Unfortunately for cash managers, the more investors infer, the more they interfere. The yield curve has now completely inverted. For those of us who expect at most 75 basis-points of cuts in the fed funds target range (now 5.25-5.5%) by year-end, it’s hard to rationalize buying securities offering the corresponding deflated yields.

Money fund recalibration nears its end 

The last stage of the SEC’s new money fund rules will be implemented Oct. 2. The industry landscape is likely settled, with about a third of the institutional prime products either dissolved or reconstituted as government funds. We continue to think clients will see value in institutional prime and muni products in both the near and long term. The latter could be driven by how, historically, the yield of money funds decline slower than securities tied to overnight rates that should immediately fall when the Fed cuts. We think the amount of industry inflows to money funds in August attests to their attraction. The situation is not guaranteed to repeat that performance, of course. But however that turns out, we think the role that prime and muni liquidity products traditionally play in portfolios will not diminish.

Global central banks

With the summer holiday and the Fed’s monetary policy symposium in Jackson Hole, Wyo., only a few developed country central banks met in August. Sweden’s Riksbank cut its main rate by 25 basis points to 3.5%, citing falling inflation that could lead it to reduce rates as much as 75 basis points by year-end. In contrast, the Reserve Bank of Australia and the Bank of Korea held benchmark rates at previous levels of 4.35% and 3.50%, respectively, though the former said inflation is proving persistent and the latter signaled easing may arrive soon. The Bank of Japan (BoJ) likely welcomed a break after its hike in July contributed to the market turmoil in early August. However, in remarks mid-month, Governor Kazuo Ueda said additional hikes are on the table as the BoJ continues to normalize policy.