Fixed income in strong position with Fed cut a done deal

It feels as though market news hasn’t taken a holiday so far this summer. From the US on Wednesday we got the minutes of the Federal Reserve’s (Fed) July 30-31 policy meeting, and revisions to a whole year of non-farm payrolls (NFP) data from the Bureau of Labour Statistics (BLS). Thursday morning brought flash Purchasing Managers’ Index (PMI) surveys for August in Europe and the UK. For investors, all of them were worth a look.

There was certainly a dovish tone to the Fed minutes, reflected in statements such as: “several (participants) observed that the recent progress on inflation and increases in the unemployment rate had provided a plausible case for reducing the target range 25 basis points at this meeting or that they could have supported such a decision.” There were also comments about the fact that monetary policy is restrictive, and that considering the disinflationary trends, it is in fact becoming more restrictive in real terms. Growth was characterised as “solid” while there were participants who “noted the risk that a further gradual easing in labor market conditions could transition to a more serious deterioration.” On the other hand, “several participants remarked that reducing policy restraint too soon or too much could risk a resurgence in aggregate demand and a reversal of the progress on inflation.”

Our reading is that a rate cut from the Fed on September 18 is a done deal. At the time of that July meeting (i.e. just before the weak August 2 NFP report wreaked havoc) there appears to have been no serious consideration of a 50bp cut. We think this is still the case, though the labour market report due September 6 could of course change this if it shows another marked deterioration in the unemployment rate; the consensus according to Bloomberg is for a small decline from 4.3% to 4.2%. If this turns out to be the number, we think the Fed will cut by 25bp.

Moving on to the NFP revisions, the BLS reported that total payroll employment for the 12 months to March 2024, not seasonally adjusted, was 818k lower than initial estimates. Although this is a large downward revision, we doubt it will change the Fed’s views too much. NFP reports have been notoriously volatile, the unemployment data wasn’t revised, and even after their revision past payroll numbers continue to look strong. In addition, the Fed chair Jerome Powell himself had already recognised at his press conference on June 12 that the payroll numbers “may be a bit overstated.” For all these reasons, we don’’t think the revision is too important for the Fed. It will be the relatively sharp rise US unemployment since March, and whether this trend looks set to continue, that will be a far bigger factor in the Fed’s (and market’s) thinking.

Last but not least, flash August PMIs on Thursday morning showed Germany continues to underperform both expectations and its neighbours, while overall the Eurozone is seeing a mild but noticeable bounce from the flat growth of H2 2023. The Eurozone composite PMI increased from 50.2 to 51.2, far ahead of the 50.1 expected, thanks mainly to a stronger services sector while manufacturing continues to struggle. For the UK the flash PMI estimate was an impressive 53.4, outpacing consensus and with a more balanced picture between manufacturing and services. In our opinion, these numbers confirm that growth in the Eurozone and the UK is gradually moving towards their potential GDP growth rates of 1-1.5%, a far healthier picture than the technical recessions witnessed in the UK and certain Eurozone countries last year.

A common question we’ve had from clients lately is whether, with growth bouncing back, the Eurozone and the UK are in the earlier stages of a new cycle. It is a valid question, but we don’t believe this is the case. The pandemic in 2020 synchronised economic cycles around the world, with pretty much every country suffering an extremely steep fall in GDP followed by an equally sharp bounce thanks to monetary and fiscal policy measures and the deployment of vaccines. Since then, growth has been cooling off around the globe in line with the retirement of some of this stimulus, higher interest rates, and dwindling consumer savings. In Europe, these growth trends were interrupted by Russia’s invasion of Ukraine, which took a toll on consumer confidence, caused energy prices to skyrocket and resulted in much lower growth than otherwise. Now that the energy crisis is over, we think we are moving back towards positive growth but below historical longer term trends and thus more consistent with late cycle conditions.

Data suggests that trends in place in the US and Europe continue to develop roughly as expected, in spite of the recent volatility. The Fed will start cutting rates in September, while future cuts and the pace of the monetary relaxation cycle will depend on data. If the labour market deteriorates rapidly then the Fed will cut more aggressively. If not, the Fed can afford to be more patient and wait for the stubborn services inflation numbers to fall further before taking rates significantly lower. In Europe and the UK, growth is gradually rising towards the 1% mark, though we do not believe this is bringing about demand side inflationary pressures that might interfere with the rate-cutting plans of the European Central Bank and the Bank of England.

This environment is a good one for fixed income, as government bonds should be well supported while credit spreads are likely to trade sideways in the absence of a spike in either defaults or growth. Despite short term volatility episodes, carry continues to be the engine of total returns for medium term investors, and with the yields on offer being quite attractive we think fixed income investors are unlikely to be disappointed.