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- [00:01]
A
Welcome to Thoughts on the Market. I'm Matthew Hornbach, global head of MacroStrategy.
- [00:05]
B
And I'm Michael Gapen, Morgan Stanley's chief U.S. economist.
- [00:09]
A
Today, a look back at last week's meeting of the Federal Open market committee, or FOMC, and the path for rates from here, it's Tuesday, August 5th at 10:00am in New York. Mike, last week the Fed met for the fifth time this year. The committee didn't provide a summary of their economic projections, but they did update their official policy statement. And of course, Chair Powell spoke at the press conference. How would you characterize the tone of both?
- [00:40]
B
Yeah, at first the statement I thought took on a slightly dovish tone for two reasons. One unexpected, the other expected. So the committee did revise down their assessment of growth and economic activity. They had previously described the economy as growing at a quote, solid pace. And now they said, you know, know the incoming data suggests that growth and economic activity moderated. So that's true. That's actually our view as well. We think the data points to that. The second reason the statement looked a little dovish and this was expected, is the Fed received two dissents. So Governors Bowman and Waller both dissented in favor of a 25 basis point rate cut at the July meeting. But then the press conference started and I would characterize that as Powell having at least some renewed concerns around persistence of inflation. So he did recognize or acknowledge that the June inflation data showed a tariff impulse. But I'd say the more hawkish overtones really came in his description of the labor market, which I know we're going to get into. And we've been kind of wondering and asking implicitly, is the Fed ever going to take a stand on what constitutes a healthy and or weak labor market? And Powell, I think put down a lot of markers in the direction. That said, it's not so much about employment growth, it's about a low unemployment rate. And he kept describing the labor market as solid and in healthy condition and at full employment. So the combination of that suggests it's a higher bar in our mind for the Fed to cut in September and.
- [02:22]
A
On the labor market. If we could dig a little bit deeper on that point. It did seem to me certainly that Powell was channeling your views on the labor market.
- [02:32]
B
I wish I had that power, but thank you.
- [02:34]
A
Well, I'd like to now channel your views and of course his views to our listeners. Can you just go a little bit deeper into this dichotomy that you've been highlighting between the pace of job growth and the unemployment rate itself, you know.
- [02:48]
B
Our thesis and what we've laid out coming into the year, and then we think the data supports is the idea that immigration controls have really slowed growth in the labor force. And what that means is the break even rate of employment has come down. So even as economic growth has slowed and demand for labor has slowed and therefore employment growth has slowed, the unemployment rate has stayed low. And there's some paradox in that normally when employment growth weakens, we think the economy is rolling over. The Fed should be easing, but. But in an environment of a very slow growing labor force, the two can coincide. And there's tension in that, we recognize. But our view is the more the administration pushes in the direction of restraining immigration, the more likely it is. You'll see the combination of low employment growth but a low unemployment rate. And our view is that still means the labor market's tight.
- [03:48]
A
Indeed. Indeed. Just one last question from me. How are you thinking about the Fed's policy path from here? In particular, how are you looking at the remaining data that could get the Fed to cut rates in September?
- [04:03]
B
Yeah, I think there's no magic sauce here, if you will, or secret sauce. Powell essentially is laying out a case where it's more likely than not inflation will be deviating from the 2% target as tariffs get passed through to consumer prices. And the flag that he planted on the labor market suggests maybe they're leaning in the direction of thinking the unemployment rate is likely to stay low. So we just need more revelations on this front. And the gap between the July and the September FOMC meetings is the longest on the Fed's calendar. So they will see the 2 inflation reports and 2 labor market reports. And again, just to provide context and color. Right. What I think Powell was doing was positioning his view against the two dissents that he received. So where, for example, Governor Waller laid out a case where weaker employment growth could justify cuts, Powell was reflecting the view of the rest of the committee that said, well, it's not really employment growth, it's about that unemployment rate. So when these data arrive, we'll be kind of weighing both of those components. What does employment growth look like going forward? How weak is it, and what's happening to that unemployment rate? So if the Fed's doing its job, this shouldn't be magic. If the labor market's obviously rolling over, you'll get cuts later this year. If not, we think our view will play out and the Fed will be on the sideline through, you know, early 2026 before it moves to rate cuts then. So, Matt, what I'd like to do is turn from the economics over to the rates views. How did the rates market respond to the meeting, to the statement to the press conference? How are you thinking about the market pricing of the policy path into year end?
- [05:53]
A
So initially when the statement was released, as you noted, it had a dovish flavor to it. And so we had a small repricing in the interest rate market, putting a little bit of a higher probability on the idea that the Fed would lower rates in September. But then as Chair Powell began the press conference and started to articulate his views around both inflation and the labor market, we saw the market take out some probability that the Fed would lower rates in September. And where it ended at the end of that particular day was putting about a 50% probability on a rate cut and as a result a 50% probability of no rate cut, leaving the data to really dictate where the pricing of that meeting would go from there. That to me speaks to this data dependence of the Fed, as you've discussed. And I think that in the coming weeks we get more of this data that you talked about, both on the inflation side of the mandate and on the labor market side of the mandate. And ultimately, if they end up going in September, I would have expected the market to have priced most of that in ahead of the meeting. And if they end up not cutting rates in September, then naturally the market will have moved in that direction ahead of time. And again, I think what ends up happening in September will be critical for how the market ends up pricing the evolution of policy in November and December. But to me, what I think is more interesting is your view on 2026. And in that regard, the market is still some distance away from your view that the fed goes about 175 basis points in 2026.
- [07:43]
B
Yeah, I mean, we're still thinking the lagged effects of tariffs and immigration will slow the economy enough to get more Fed cuts than the market's thinking. But we'll see if that happens. And maybe that's a topic we can turn back to and upcoming thoughts on the market. But what I'd like to do is ask you this. I've been reading some of your recent work on term premiums and in my view had this really interesting analysis about how the market prices Fed policy and how U.S. treasury yields then adjust and move. You highlighted that treasury yields built in a term premium after April 2nd. What's happening with that term premium today?
- [08:23]
A
Yeah, the April 2nd Liberation Day event catalyzed an expansion of term premia in the treasury market. And ultimately what that means is that treasury yields went up relative to what people were thinking about the path of Fed policy. And of course the risks that they were thinking about in the month of April were risks related to trade policy. Those risks have diminished somewhat, I would argue, in the subsequent months as the administration has been announcing deals with some of our trading partners. And then the market's focus turned to supply and what was going to happen with U.S. treasury supply. And then of course the reaction of investors to that coming supply. And I would say given what the treasury announced last week, which was it had no intention of raising supply in the next several quarters and our view is that the US treasury will not have to raise supply until the early part of 2027. So way off in the distance. So investors are becoming more comfortable taking on duration risk in their portfolios because some of that uncertainty that opened up after April 2nd has been put away.
- [09:41]
B
Yeah, I can see how the substantial tariff revenue we're bringing in could affect that story. So, for example, I think if you annualize the run rates on tariffs, you'll get something over $300 billion in a 12 month period. And that certainly will have an impact on treasury supply.
- [09:57]
A
Indeed. And so as we make our way through the month of August, we'll get an update to those tariff revenues. And also at towards the end of August we will have the Economic Symposium in Jackson Hole where Chair Powell will give us his updated thoughts on what is the outlook for the economy and for monetary policy. And Mike, I look forward to catching up with you after that. Thanks for taking the time to talk today. Great speaking with you Matt, and thanks for listening. If you enjoy thoughts on the market, please leave us a review wherever you listen and share the podcast with a friend or colleague today. The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for you.