Revisiting Rate Outlook Amid Political Reactions and Fed Anticipations

Revisiting Rate Outlook Amid Political Reactions and Fed Anticipations 

As the 10-year Treasury approaches the lower end of our 4.3% to 4.5% range, amidst analyzing jobs data and preparing for the Federal Reserve's next moves, it's a fitting moment to reassess and clarify our rate outlook. Before delving deeper, it's prudent to consider the political reaction to the anticipated first rate cut by the Fed this year, as it will likely influence the timing of their decision.

Former President and likely Republican nominee, Donald Trump, is expected to use social media and his campaign to argue that the Fed's actions are favoring Democrats and are politically driven to support the current president despite inflation issues. Conversely, President Joe Biden, the presumptive Democratic nominee, will likely tout the rate cut as evidence that his economic policies are effective and that the economy is thriving. Public opinion will be divided, which is significant. Although the Fed might not factor this into their decision, I personally wouldn't recommend making the first cut in September.

Utilizing Bloomberg's WIRP function, we can see market predictions as of Tuesday, June 2nd. The market anticipates a high likelihood of a cut by September, with an 80% chance of a cut before the election. I believe the Fed aims to make a single cut to demonstrate that their policies have succeeded—tightening appropriately and slowing inflation without triggering a recession. Despite the data, the Fed is likely to cut this year to signal success. If the data is strong, they might refrain from cutting, but current signals are ambiguous.

I favor a cut in July, estimating a 25 basis points reduction, potentially 50 basis points if job data is particularly weak. July is preferable over September to avoid election-related political noise and because it's a peak holiday period, likely reducing public attention. Following the initial cut, I expect one or two additional cuts this year, likely in November and December, with an overall reduction of 75 basis points through two or three cuts, starting earlier than the market currently predicts.

In June, we'll receive an updated Summary of Economic Projections. I anticipate the median projection to suggest two cuts, aligning with the previous mean. Fed Chair Powell is likely to signal a July cut despite the dot plot, and discussions on the longer-term yield levels will continue, considering recent debates about the appropriate level of long-term yields.

There's speculation that normal long-term yields might be higher than 3%, especially given the potential productivity boost from AI. Although premature to focus on the terminal rate, it will become more relevant after the first cut, likely leading to increased terminal rate projections and some normalization of the yield curve.

There are several factors that could influence yields. On the positive side, the Birth/Death model and seasonal adjustments may overestimate job growth, suggesting a weaker employment situation than perceived. Despite strong consumer spending, rising credit use and inflated prices might indicate an underlying fragility. Compared to other major economies, the U.S. offers attractive yields, supported by a strong dollar. Increased production from China and India could reduce inflationary pressures on goods.

However, on the negative side, the growing deficit and increasing auction sizes could lead to higher yields, especially if investor confidence wanes. Declining Treasury holdings by China and Japan's preference for domestic bonds could decrease demand for U.S. Treasuries. Potential geopolitical disruptions and increased demand from a growing Indian economy could push yields higher. On-shoring and near-shoring trends, along with government subsidies and increased energy demand, could drive inflation during their implementation phase.

Leading up to the Fed meeting, I expect yields to decrease slightly, with the 10-year Treasury potentially falling to 4.2%. However, I anticipate a rebound above 5% by year-end.