Shifting Gears: Fed's First Rate Cut and Q3 Dynamics
Third Quarter, 2024
John R. Sides, CFA
As inflation data moderated and growth remained intact, the third quarter witnessed the long-anticipated initial rate cut by the Federal Reserve. Having all but declared victory on inflation, the message from Powell was that it is time to shift focus towards the other half of the dual mandate – maximum employment. The Fed pointed to weakening payrolls data and opted for a 50 basis point first cut as opposed to a 25 basis point cut. The yield curve steepened significantly as the 2-year U.S. Treasury yield fell 111 basis points from 4.75% to 3.64% during the quarter. The forward curve is pricing in a very aggressive cutting cycle, culminating in a terminal Fed Funds rate of approximately 2.90% by the end of 2025. In the context of a 3% Federal Funds rate, a 10-year Treasury yield of 3.78% and 30-year Treasury yield of 4.11% – the quarter-end levels – seem reasonable (for now). While short-dated rates are headed lower, the path for longer-dated yields will undoubtedly hinge on the balance between growth, inflation, and the fiscal implications of the next administration.
Recent consumer price index (“CPI”) prints have shown a promising trend lower. The September report showed a headline CPI print of 2.5% year-over-year, a drop from 2.9% in the prior month and the lowest print since February 2021. This was in part driven by a sharp decline in energy prices. Core CPI, which strips out the food and energy components, was stickier at 3.2% on a year-over-year basis. Looking at the sub-components of the inflation report, you will find the primary culprit: stubborn shelter costs. Owners’ equivalent rent (“OER”), which comprises almost 27% of the total CPI calculation, rose by 5.4% versus the prior year period. A historically lagging indicator, OER should eventually roll over as the supply of multi-family units increases. Regardless, the inflation progress made was enough justification for the Fed to lower the Fed Funds rate by 50 basis points.
Despite some bouts of volatility and rather severe drawdowns along the way, risk assets powered ahead during the quarter. The equity rally broadened from a previous concentration in the technology sector, and credit spreads tightened in sympathy. Corporate credit performed well as the bid for high quality duration remained intact and the probability of a ‘soft landing’ rose. Spreads tightened across the quality spectrum and credit curves flattened at the margin. Securitized products performed well as the agency mortgage-backed securities basis tightened and various flavors of asset-backed securities and commercial mortgage-backed securities were in demand, particularly in the front end of the curve. The relative value proposition of structured products versus corporate credit, at a high level, remains in place. Now that the Fed has embarked, investor focus turns to the pace of their easing cycle, the upcoming election, and flaring geopolitical tensions.
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