Macro
Federal Reserve Chair Jay Powell’s comments and updated interest rate forecasts aim to reinforce a “Goldilocks” narrative—suggesting that economic conditions are neither too hot nor too cold while inflation continues moving in the right direction.
The big question for the upcoming week is whether the Federal Reserve will cut rates by 25 or 50 basis points (bps). The market is debating this first cut and trying to confirm if inflation has been permanently contained, as it has improved significantly and is steadily moving toward the Fed’s target. Investors are starting to get comfortable with inflation expectations remaining in the 2-3% range.
This week, the probability of a large 50 bps cut has increased to approximately 50%, making both a 25 bps and a 50 bps cut equally likely. However, we haven’t heard any indications from the Fed that might lead us to believe a larger cut is appropriate, and in the past, 50 bps “jumbo cuts” were more clearly communicated. Nevertheless, the size of the initial cut might not be as important, as the rate-cut cycle is only beginning, and investors know there is much more easing to come regardless of the initial move. The Overnight Index Swap (OIS) markets anticipate 250 bps of easing over the next 12 months. Such a significant cut would be appropriate only if the economy slows significantly from here.
TThe Federal Reserve must address the economic slowdown without seeming far behind the curve to avoid panic—a tightrope balancing prompt action against negative market signals. A measured rate cut is supported with five-year forward inflation expectations at 2%, matching the Fed’s target. Chair Jerome Powell may require more evidence of economic weakness before acting aggressively. Upcoming payroll data could significantly impact Fed decisions. A softening labour market might prompt faster rate cuts, possibly justifying a 50 basis point reduction. However, the Fed may opt for a 25 basis point cut, monitoring data, and increasing easing if necessary. An immediate 50 basis point cut might be seen as an emergency measure, raising concerns about the economy’s health.
The credit market signals a soft landing, while the rates market signals a high recession probability. To reconcile that, there will likely be more volatility. Some investors are worried that if the Fed cuts by 50 bps, the U.S. economy might become overstimulated, leading to further inflation spikes by 2025 if rates are lowered too aggressively. Additionally, due to deglobalization and high government spending, there is strong resistance to bringing inflation back to 2%.
We are coming from an unprecedented period of fiscal stimulus and the highest inflation in decades. The worry is that while inflation is slowing, the economy might be slowing even faster. The primary concern is a slowdown in consumer spending and a weakening labour market. As investors worry about the consumer’s health, they observe consumer spending data. Consumer spending rose 0.9% in August from July, with growth led by travel, clothing, furniture and home furnishings, and general merchandise stores. Consumer debt delinquencies are rising from a low base and mostly in floating interest rates. U.S. Retail Sales report for August, scheduled for release on Tuesday, September 17th, is expected to increase by 0.2% from July.
People are talking about the Sahm Rule discussed in past weeks, but similarly, we can apply the Simple Moving Average of the unemployment rate. There has never been a case where the 3-month moving average of unemployment has risen by more than one-third of a percentage point (33 bps) without a recession. Both rules have one thing in common: they measure the momentum of unemployment. Unemployment tends to have a cyclical growth pattern, meaning that during an economic slowdown, it will grow slowly and then suddenly accelerate and spike. The spike in the unemployment rate is followed by a return to the mean (mean reversion), where the decline slows as it crosses the mean. As the increase is sudden, it’s very difficult to predict, but once in motion, things tend to “get worse before they get better.”
Next week will be critical for interest rates as the U.S., Brazil, the U.K., and Japan’s central banks set interest rates. We have U.S. Empire Manufacturing on Monday and the U.S. Retail Sales print on Tuesday. Most importantly, we will have the Fed’s decision on Wednesday during the Fed conference, followed by U.S. Jobless Claims and Existing Home Sales on Thursday. Investors will also carefully watch the Bank of England’s decision on Thursday and the Bank of Japan’s decision on Friday.
Rates
The bond markets are experiencing significant demand, particularly in Europe, where investors are eager to lock in the region’s highest yields. This week, Italy issued €8 billion in bonds, met with an overwhelming €130 billion in demand—this strong appetite for locking in rates amid an expected economic slowdown.
Since April, both the short and long ends of the yield curve have moved downward, resulting in a parallel shift that has pushed the entire curve lower. However, the back end of the curve presents challenges, as it currently needs a substantial term premium. This absence makes long-term yields more susceptible to volatility, especially if investor expectations shift suddenly.
Over the past month, the front end of the yield curve has reacted sharply, aligning market expectations with where the Fed’s policy rates are likely to be over the next year. However, investors are growing cautious about pushing yields too far down and are concerned about diminishing returns.
This trend is influenced by the risk premia being priced into the rates market, reflecting investor concerns about future economic growth. This downward movement on the yield curve led to improvement in the financial condition indexes, which reflected an easing of fiscal conditions.
The monthly returns on the aggregate Treasury index have been positive, registering gains between 1-2% each month for the last five months. Despite this steady performance, the absence of a significant term premium— a typical feature when investors anticipate negative economic developments and growth concerns.
Some analysts interpret current Treasury yields as reflecting not only the expected rate cuts by the Fed but also a heightened risk premium associated with the possibility that the economy may be slowing more than recent macroeconomic reports indicate. This perspective suggests that bond markets are pricing increased economic risks, leading to a flattening or inversion of the yield curve.
A long-duration bond strategy could be advantageous in the current environment as the economy shows signs of slowing. Whether the Fed decides on a 25- or 50-basis-point cut in the upcoming meeting, investors might consider maintaining above-benchmark duration exposure. This approach could benefit from declining yields and potential capital appreciation in long-term bonds.
Investors, however, must remember that compressed yields and risk premia increase sensitivity to changes in macroeconomic conditions. This makes the rates market prone to volatility spikes, especially in its less liquid segments.
Credit
While the treasury market signals an economic slowdown ahead, the credit market appears to indicate a soft landing. This divergence is largely driven by the pent-up demand to lock in attractive yields across the fixed-income markets, which is pushing down treasury yields and compressing credit spreads.
The high demand for fixed-income assets creates heightened sensitivity to changes in macroeconomic conditions, making the bond market prone to volatility spikes. Investors remain focused on the total yield perspective, which continues to appeal despite potential market fluctuations.
This week, we witnessed significant activity in the investment-grade (IG) market, with $38 billion in new issuance pushing the year’s total sales to over $1.2 trillion. The high-yield (HY) market was also busy, featuring 15 issuances this week alone, bringing the month’s total sales to $19 billion. This robust issuance reflects strong investor appetite for corporate bonds across the credit spectrum.
A convergence occurs between private credit and public markets, suggesting that the liquidity premium may decline over time. Notably, Apollo plans to partner with State Street to launch a publicly traded ETF to provide investors access to private credit. From the public market perspective, while top-quality segments are highly liquid, smaller companies and lower-quality segments face significant illiquidity.
High-yield spreads are near historic tights. However, if the bottom 20% of the lowest-quality companies are excluded, the remaining top 80% are experiencing record-tight spreads. This indicates strong investor confidence in higher-quality issuers within the high-yield market.
There is currently a 200 basis point spread between private and public credit in the HY market. In the IG space, the spread available in the public market is double that of the private market. Due to these spread differentials, private credit presents significant relative value from an investor’s perspective. There will be anticipated convergence between private and public credit markets, with the spread narrowing over time as more investors are able to access private markets through new financial products.
Overall, the credit market remains robust despite signals of an economic slowdown from the treasury market. Investor demand for fixed income remains strong, driven by attractive yields and confidence in corporate balance sheets.
Equities
U.S. equities rebounded strongly this week, led by major technology stocks amid positive momentum in the artificial intelligence (AI) sector and a recovery from oversold conditions. This follows last week’s significant downturn, where the S&P 500 recorded its worst performance since March 2023 and the Nasdaq since January 2022.
Notably, NVIDIA soared by 15.8%, Amazon climbed by 8.8%, and Microsoft advanced by 7.2%, marking standout performances among big tech companies, while Apple lagged with a modest gain of 0.7%. While there is a growing concern that Mag-7 stock valuations are stretched, most continue to lead the market performance this year. The equal-weighted S&P 500 index underperformed the official index by 134 basis points, indicating that larger-cap stocks were the primary drivers of this week’s gains.
Several sectors experienced notable outperformance. The semiconductor industry shone, with the Philadelphia Semiconductor Index (SOX) rising by 9.9%. Information technology services and software companies also fared well, exemplified by Oracle’s impressive 14.3% surge following strong earnings results. The housing market strengthened as homebuilders advanced, and industrial sectors like machinery and railways contributed positively. The transportation sector benefited significantly, with airlines such as Alaska Air Group jumping 10.8% and cruise lines gaining traction, reflecting increased investor optimism in the travel and leisure industries. In the financial realm, asset managers outperformed, buoyed by favourable market conditions. Precious metals miners saw gains amid rising gold prices, which climbed 3.4% to reach a new record high.
Conversely, some sectors underperformed. The energy sector lagged despite a modest rise in crude oil prices, which ended the week up 1.2% after the previous week’s sharp selloff. Financial institutions, particularly money centre banks, faced declines amid a complex interest rate environment. Consumer-focused industries such as cosmetics, protein producers, and household products experienced weaknesses, possibly due to shifting consumer preferences and cost pressures. The media sector also saw downturns, reflecting challenges in advertising revenues and content production costs.
As the economy slows and consumers become more price-sensitive, early cyclical and defensive sectors have led the market over the past month, with real estate, regional banks, homebuilders, defensive industries, financials, and surprisingly non-profitable tech stocks being the best performers. Small-cap stocks have also outperformed large-caps during this period.
Investors are positioning themselves toward defensive sectors, as these equities often outperform in bear markets and during bull markets for bonds. Equity valuations remain elevated, with the S&P 500 trading at 20.8 times forward earnings—20% below the 2000 dot-com bubble peak of 24.8—but at 2.9 times sales, 23% above the dot-com peak. Falling interest rates may reduce dollar financing costs, potentially easing financial conditions.