Is the economy on track for a soft landing?

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Phoebe White: Welcome to Research Recap. I'm your host, Phoebe White, Head of US Inflation Strategy. And today I'm joined by Mike Feroli, our Chief US Economist, and Jay Barry, Co-head of US Rate Strategy, to talk about how we're reading the recent economic data, the path ahead for inflation and fed policy, both in the next couple of meetings and into next year, and our expectations for US Treasury yields, thinking about the risks coming from supply and demand as well as the Fed path from here. 

Mike And Jay, thanks so much for joining us today.

Mike Feroli: Good to be here.

Jay Barry: Thanks for having us.

Phoebe White: So, Mike, let's start with you. Maybe you could walk us through just what you're seeing in the data. I know you took out your call for a recession a few months ago. So far, you know, we continue to see signs of resilience. Just in the last two weeks, we had upside surprises on both jobs, growth and inflation. Why do you think the economy hasn't shown more signs of slowing after more than 500 basis points of policy tightening? And how are you thinking about the outlook for growth going forward?

Mike Feroli: Yeah. So as you mentioned, economy is looking pretty resilient here. The quarter we just completed had the economy growing at over a 3% annual rate. We do think things will step down as we move into the fourth quarter and on into 2024. But as you mentioned, we've been surprised by the resilience of the economy here. I think a couple of factors could be at play. One is, I think some of the post pandemic tailwinds were just stronger than we had anticipated. And I think we probably also got a little more support from fiscal policy than we were anticipating. We do think both of those things are kind of time limited. And as we get further out into next year, that we will see weakness continued to build.

Phoebe White: Okay, so softer growth ahead. Let's talk about inflation. Because even alongside above trend growth and tight labor markets, we have actually seen both headline and core inflation falling pretty dramatically from their peaks. For context, core PCE inflation peaked at 5.6% on a 12-month basis last year. It's fallen to 3.9% as the most recent reading. On a three month annualized basis, it's actually running just 2.2%. Core CPI was also running 2.4% annualized in the three months through August. Well, we did see a re-acceleration in September. And if you look at the details of the report, it seems to suggest we could see some firmer readings through the fall. So how are you thinking about the inflation process? And how do you think the Fed would respond to a string of somewhat stronger readings in core inflation?

Mike Feroli: Right, so as you mentioned, we have had this disinflation occur alongside resilient growth. I think some of that is the dreaded transitory story actually having some validity to it, which is to say, particularly in goods inflation, a lot of the things that really pushed up inflation were related to supply disruptions that have mostly ameliorated themselves. However, I'd also say that you're seeing something similar in wage inflation, right? And you've had, I think, average hourly earnings go from like a local peak of 59, if I recall correctly, to 4.2 recently, and that's also occurred without any material move up in the unemployment rate. So I do think, you know, there are two you're also seeing that are supply performance on labor markets. And I do expect that to also feed through eventually to softer service inflation going forward. So while we see Core CPI this year on a Q4 Q4 basis at 4%. Next year, we have it coming down a little further to 2.7%. So not quite back to a completely comfortable place. But we do think that this disinflation has further room to run.

Phoebe White: Okay, and so what does that mean for the Fed here? I guess, just looking to the November meeting, and then even beyond then, we have had some more dovish commentary from Fed speakers recently. But how are you thinking about the Fed from here?

Mike Feroli: So I think for November, as you'd mentioned, there have been some pretty dovish, I would say, comments very much a wait and see attitude. We think given that, that it seems like November is very likely a meeting that they're on hold. December could get interesting if we have a repeat of some of the strength, and the CPI and employment reports that you mentioned at the outset. So that does raise risk for December. Last week's CPI probably reinforced that risk. But we still think that they will be on hold in December. And I would add that there's... the risk of government could be shut down at the time of the December FOMC Meeting. So that would also be a reason for them to be a little more cautious. So we do think we have reached the peak in the funds rates, with some risks that they could go again in December if the data comes in hot.

Phoebe White: And I know a lot can happen between now and next year, but looking beyond the next couple of meetings, if your forecast is correct and we do see a soft landing next year, at what point do you think the Fed will feel comfortable beginning to ease?

Mike Feroli: Right. So, in our forecast, we have some modest rate cuts in, beginning in the third quarter of next year. That's a forecast and forecasts (laughing) often don't pan out. And I could see a scenario where the Fed is on hold at these rates for all of next year. Certainly that wouldn't be unprecedented if you went back to the '90s. On the other hand, if things come in little softer, I think we get some negative payroll prints, the cutting could be more aggressive than we have in our forecast.

Phoebe White: Okay. Thanks, Mike. Let's turn to you, Jay. So how does this translate across to the US rates markets? We have 10-year yields down from their peak at the time of this recording sitting near 470. But that's still up close to 90 basis points in the last few months. Real yields are up by a similar amount. How much of this yield move do you think can be attributed to markets pricing in a higher for longer Fed and what other factors are contributing to the move?

Jay Barry: Sure, Phoebe. So I think at least the early onset of the move to higher rates in the late part of the summer, one, could directly attribute to some of the factors that Mike was talking about. A growing understanding of the greater resilience of the US economy. Mike, I think we raised our second half growth forecast by about two and a half percentage points over the course of the summer that would naturally translate through to higher rates, not just through the growth channel, but also because we managed to price in the Fed Funds Rate peaking later. I think back in the early part of the summer, we were pricing in the Fed would be on hold by now. Whereas now markets are pricing a peak in the Fed Funds Rate sometime early in 2024. And finally, this is translated through to higher for longer, as well as markets are still pricing in Fed cuts in the second half of 2024. But about 40% of what was priced in the summer has been removed. So I think in aggregate, at least the first half of the move to higher yields, one could attribute to this sort of greater resilience that we've talked about and higher for longer. But more recently, since September, the drivers of change because I think the markets Fed and growth expectations have been relatively stable. But inflation, forward inflation expectations have risen modestly. And that can explain some of the move here. But in aggregate, we look at the moves over the last month or so, we cannot explain versus those fundamental drivers which have explained anywhere between 90 to 95% of the variation in tenure yields over the last 10 to 15 years, we can only explain about 50% of that move. The remainder is unattributed and I think one could talk to it more about in the context of some term premium. And it means that long term treasury yields are now more dislocated from these fundamental drivers than they've been at any point over the last year. The last time we saw a similar dislocation was in the fall of 2022 when we were going through hawkish developed markets central bank policy shifts, but also the UK LDI deleveraging. And prior to that, we really need to go back to either the spring of 2020, or potentially the summer of 2013, in the taper tantrum to see it, the magnitude of divergences that we are seeing right now. So while in aggregate, we can see fundamentals driving a lot of this move, it cannot explain all of it, and at least the last 35 to 40 basis points seems to be away from the fundamentals.

Phoebe White: So, I know you've written a lot about the supply and demand imbalance in the treasury market and how that could be contributing to higher term premiums. But how do you think about where yields are headed from here when we have a Fed potentially on hold, but these factors that are sort of pushing term premium higher?

Jay Barry: I think ordinarily if we start with the Fed and Mike's Fed outlook, that if we feel comfortable from here that the Fed is on hold, not just at the next meeting on November 1st, but likely on hold for the duration, that should be something supportive of yields peaking. And historically in other fed tightening episodes, that meant once the Fed was done, there's also scope for yields to decline. And in average, over the last 30 years, we have seen intermediate treasury yields have declined 60 to 80 basis points once the Feds on hold. Our case here has been the scope for yields a decline is smaller than it's been in the past. One, because Mike's talked about this inflation outlook and how it's likely to be persistently above 2%, at least through year-end next year, which is translating to a Fed that will be on hold for the better part of the next 12 months because on average over the last 30 years, the Fed's been lowering rates within seven or eight months of that last hike. Second is even though the Fed policy rate tightening cycle is likely done, the balance sheet tightening cycle is not yet complete. And the Fed is continuing to draw down its balance sheet, its treasury holdings by $60 billion per month, mortgage holdings have been falling by about $20 billion per month. It's not just in the US, but it's sort of synchronized globally, because the Bank of England and the European Central Bank are also sort of running through balance sheet normalization as well. So this in the background is something that should contribute to yields remaining elevated for a longer period of time. And as you said, Phoebe, it's all coming against the backdrop of a demand backdrop which is shifting rather quickly. We've acknowledged and talked about numerous times in our research how for the last 20 years, the Treasury market has been bolstered by the support of three price insensitive investors, of which the Fed is a really important one. But away from that, the US Commercial Bank Community who have been large marginal buyers of treasuries in the past, and in particular, during the recession of 2020/21, in the foreign community, we think it's unlikely that their holdings and their demand will keep pace with the growth of the Treasury market on a go forward basis. It matters because those holders are all more price insensitive in the nature of their demand. And we're shifting the Treasury market to more price sensitive demand. And this is coming against the backdrop of deficits that are still running 5-plus percent of GDP. And also coming at a time where we've managed to digest Treasury supply rather easily the last six months or so, but largely because it's been at the short end of the curve in the form of treasury bills. The Treasury is at the early stages of increasing long term coupon auction sizes. And we think that this is going to mean that Treasury duration supply is going to increase by about 30%, between 2023 and 2024. So when we put the pieces of the puzzle together, it all makes us think that over the medium term, long term rates, even though the Fed's on hold, are going to remain more anchored at higher levels for longer periods of time. We think it translates into steeper yield curves over time, we also think it translate to sort of a cheapening of the belly. And you know, we've talked about ways that you can mimic rising term premium exposure through those sorts of exposures as well.

Phoebe White: And maybe we can just dig into some of the risks around supply and demand since they do seem to be so important right now. Financing needs will depend on the fiscal backdrop, what are your thoughts there? And, and then also maybe if you could touch on how you're thinking about the runway for the Fed's QT process, clearly balance sheet normalization is also translating to greater supply to m- private investors as you mentioned.

Jay Barry: I think on the first on the fiscal outlook, this is something that Mike spends a lot of time on with our colleagues as well. And there's reasons to think that some of the widening in the fiscal deficit this year should not be repeated in fiscal 24. But at the same time, I think there's a growing acknowledgment that interest expense for the year is likely to contribute more aggressively to the bottom line and to the deficit than we previously had expected. So that could add some sort of widening pressure. So in margin, if deficits are gonna be hanging out relatively wide as a share of GDP, Treasury's funding needs are going to be continuing to grow. There's a healthy debate out there right now about whether the Treasury Department may choose to rely more heavily on T bills to prevent term premium from rising more rapidly. But to me, that would sort of be out of character with its historical behavior, where the Treasury has been telegraphing to us for six months that the gap in its funding needs are such that it will be need to be addressed vis-a-vis larger coupon auction sizes, and it likes to be a regular and predictable borrower. And if it were to sort of pivot back at this point with, if anything, the fiscal picture looking slightly worse than it did a few months ago, I think that would be resulting in somewhat lower credibility for the Treasury Department and out of character with its recent behavior. But on the flip side, you know, the issuance forecast that we've talked about are predicated on the view that the Fed's balance sheet will continue to contract through next year. And certainly, you know, Mike's talked about how he doesn't expect the Fed to begin lowering rates until the third quarter of next year. Chair Powell has talked about the likelihood that the Fed can continue to normalize its balance sheet even as it normalizes rates, which makes you think that QT has a longer runway. But the risk would obviously be coming. I think from liquidity risks, we can all go back to September of 2019 and see how repo rate spiked when reserve balances became scarce. We think we're much further away from that right now. But we know that the banking system's gone through some trauma over the course of the year. And if for some reason we begin to see sort of e- early on set signs that reserves are less ample, that could be one reason that the Fed chooses to sort of pull back on QT and thus, you know, ameliorating some of the concerns over supply that we've been talking about.

Phoebe White: Thank you, Jay. Thanks, Mike. This has been an extremely informative discussion. Thanks for coming on the podcast and, and thank you to our listeners for tuning in to Research Recap on J.P. Morgan's Making Sense podcast channel. We hope you'll join us next time.

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