Federal Reserve Impact on Markets

This time Is different We don't often say that about the Fed, but after yesterday's FOMC meeting, we think it may actually be true. In fact, we believe yesterday's meeting ushered in a new era of monetary policy in the United States.    For the better part of two decades, monetary policy has followed a familiar playbook: extensive forward guidance, frequent communication, data dependence and the  Federal Funds rate as the primary policy tool. While leadership has changed, the broader framework has remained remarkably consistent.   What we heard yesterday suggests the possibility of a meaningful evolution.   We believe the Fed may be moving toward a framework that places less emphasis on signaling every move in advance and more emphasis on assessing where inflation, employment and broader economic conditions are heading. In a world of real-time data and increasingly sophisticated analytics, that could prove to be a healthier and more effective approach.   We also continue to hear indications that the policy toolkit could broaden beyond the overnight policy rate, with greater consideration of balance sheet policy, liquidity conditions, money supply dynamics and longer-term interest rates.   Importantly, change does not automatically mean more volatility. A broader set of tools and a more forward-looking approach could ultimately increase confidence in policy outcomes rather than diminish it.   For investors, the near-term message remains straightforward: inflation is still above target and remains the Fed's primary focus. While rate hikes are far from certain, they remain a possibility that markets need to respect.   That's one reason we continue to favor income-oriented fixed income opportunities over pure interest-rate expressions. And when markets overreact to uncertainty around policy change, we think there may be opportunities to sell volatility rather than buy it.   This time may indeed be different, and it will be fascinating to watch how this evolution in monetary policy unfolds. The real question is whether less signaling creates more uncertainty, or ultimately more confidence in the Fed's ability to achieve its objectives.

Recent equity rotations reflect a downgrade to the market’s outlook for economic growth, but the prospect of Fed easing has left the S&P 500 near its all-time high. Our economists forecast the Fed will cut by 25 bp for the first time next week and expect 200 bp of easing through 1Q 2026 (vs. market pricing of 260 bp). But the trajectory of growth is a more important driver for stocks than the speed of rate cuts. The offsetting valuation impact of higher bond yields and better growth expectations imply limited scope for P/E expansion. With multiples flat, EPS growth will lead the S&P 500 modestly higher. Our year-end 2024 S&P 500 price target remains 5600. Our rolled 6-month and 12-month price targets are 5700 and 6000.

…It has begun. Over the last year, I have made the strongest possible case for the Fed to be proactive. Rates should have been cut this week – indeed, the rates should have been cut in January. We have seen this movie before. The Fed was very late to take inflation seriously in 2021. They brushed it off as “transitory”. However, it seemed obvious that inflation was surging. Real-time shelter inflation was increasing at a double-digit rate. Shelter has the largest weight in the CPI. Shelter operates with a lag. Hence, it was easy to forecast the surge. The Fed was forced to react after the damage was done. The same mistake has been repeated – despite many warnings. The recent CPI print was 3% year-over-year (YOY). Nearly two thirds of this print was driven by one component – shelter. Shelter inflation is reported at 5.2% YOY. This number is far from reality. For example, Apartmentlist.com rents are running -0.8% YOY - a full 6% below the official CPI number. Suppose we believe the real-time shelter inflation is 2%, not 5.2%. This means the real-time CPI would be 1.8%. If you believe shelter is 3%, then real-time CPI would be 2.2%. These numbers are well within the Fed’s target. The Fed prides itself on making data-driven decisions. However, it is unwise to make decisions based on stale data. The shelter inflation happened in the past. Keeping rates high will not impact what happened last year. It is always best to look at forward-looking indicators for policy decisions. ·      My yield curve indicator has been inverted for 20 months. It is 8 of 8 with no false signals since the 1960s. The maximum historic lead time has been 23 months (before the great recession). Ignore it at your own risk. ·      The Sahm Rule has been triggered. This indicator is not necessarily predictive because employment moves with the business cycle – but it is useful in telling us whether we are in a recession or not. We know that hiring has slowed and unemployment has risen – though the absolute rate is still relatively low. ·      Retail sales are highly correlated with personal consumption expenditures. Retail Sales are flat. Many do not realize that Retail Sales are not inflation adjusted. Taking inflation into account recent sales growth as well as YOY sales are negative. ·      There is considerable evidence that COVID-era savings have been drawn down. A recent release from Philadelphia Fed carried the headline: “Share of Delinquent Credit Card Balances Reaches Series High”. (The same report shows an alarming plunge in mortgage originations.) People are paying 20%+ interest on a card because their savings have run out. Indeed, if people are cutting back on fast-food expenditures, you know this is serious.  Drawing down the savings has fueled consumption expenditures over the past two years. That source of growth has ended. Now the Fed will have to play catch-up and cut by at least 50bp in September. Any recession is a self-inflicted wound. 

A very junior trader asked “what should I be paying attention to most right now?” My response was simple; “master the plumbing because it’s the key to everything. I tried explaining that “price action is like the surface of the water, but funding is the tide, so if you pay attention to funding relationships like SOFR vs EFFR/IORB or track the TGA/QT backdrop, you’ll understand why risk often turns before the headlines do.” When cash gets scarce, funding costs jump, balance sheets tighten, and leveraged risk gets cut. That pressure often hits the crowded/high-beta/AI complex first. Relief comes when the Treasury spends cash back into the system and the Fed’s balance-sheet runoff (QT) is less of a headwind. 1. SOFR > IORB = reserves are tight; primes are tightening; levered longs may come down. 2.  TGA bleeds down and QT slows, reserves rise, repo compresses, beta can catch a bid.   “PLUMBERS”  DASHBOARD ·        SOFR vs EFFR and vs IORB (direction of stress) ·        TGA path (is Treasury adding or returning liquidity?) ·        Fed balance sheet/H.4.1 (reserve trend) ·        Month/quarter-end kinks (dealer balance-sheet windows) ·        Repo color (haircuts, specials, fails, term) ·        Prime-broker updates (client leverage/margin/utilization) ·        Systematic flows (CTA/vol-control thresholds) ·        Equity factor tape (high beta vs low vol; crowded baskets)

Fed Chairman Jerome Powell indicated that the Federal Reserve is preparing for interest rate cuts, emphasizing that the time has come for policy to adjust as inflation has significantly declined and the labor market is no longer overheated. In his speech at the Fed's annual retreat in Jackson Hole, Wyoming, Powell noted that while inflation is still above the Fed’s 2% target, the progress made allows the central bank to focus equally on maintaining full employment. He acknowledged the need to adapt policy based on incoming data and evolving risks, without specifying the timing or extent of the rate cuts. On Friday, he said, “The time has come for policy to adjust,” and added, “The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.” With the Federal Reserve signaling potential interest rate cuts, investors should consider adjusting their financial planning and portfolios to align with the changing economic environment. Here are some steps to consider: 1. Review Fixed-Income Investments: Interest rate cuts typically lead to lower yields on bonds, money markets, and CDs. However, existing bonds may increase in value as their higher rates become more attractive compared to new issues. If you prefer or need fixed income, now is the time to review your positions and consult with an experienced Sun Group Wealth Partners advisor. 2. Reevaluate Equities: Lower interest rates can boost equities, particularly growth stocks, as borrowing costs decrease and economic conditions potentially improve. However, it’s important to assess sector exposure, as some industries, like utilities may perform better in a lower-rate environment. This could be favorable for those who have been waiting for mortgage rates to come down. 3. Consider Dividend Stocks: With rates potentially decreasing, the appeal of dividend-paying stocks or notes might increase, especially those with strong fundamentals. These can provide a steady income stream as bond yields decline. 4. Stay Diversified: Maintain a well-diversified portfolio that can withstand various market conditions. Diversification across asset classes, sectors, and geographies can help manage risk during periods of economic adjustment. 5. Prioritize Financial Planning: Keep your budget in line, focus on needs vs. wants, and set up auto-savings/auto-investing for your important long-term goals such as retirement or education planning for your family. This is also a good year to explore your estate-planning needs. Sun Group Wealth Partners has significant resources to assist with your future planning. 6. Stay Informed: Continue to follow our weekly newsletter and watch our videos. Together, we can monitor the Federal Reserve’s communications and economic indicators. The timing and pace of rate cuts will depend on evolving data. Thank you, and please reach out if you have any questions.

On the face of it, today's June #payrolls report was an upside surprise. #Jobs added reached 206k, higher than expected and average hourly #earnings (wages) were up 0.3% month on month or 3.9% year on year – hardly tame. But underneath the hood, it’s clear to us that the #LaborMarket is on a plateau. April and May jobs numbers were revised down by more than 50k each. The #unemployment rate continued its slow and steady tick higher. A large majority of jobs created in June were in non-cyclical sectors such as government and medical care. Importantly, cyclical job creation (i.e. retail, business services) moved lower, suggesting that upward wage pressure may ease ahead. After two years of focusing on #inflation, the #Fed is talking more about the labor market and has acknowledged that any unexpected labor market weakness could prompt them to cut sooner. What we’re seeing today is not an unexpected weakness in the labor market – everything is still fine. And though there’s still next week’s CPI print to look forward to, data since the Fed’s last meeting likely has not provided enough evidence for a cut in July. We look for a first cut in September. As for the market: so far, #investors have taken moderating activity as good news. In other words, declining #InterestRate risk has been more important than any rise in #recession risk. It’s our view that the #equity market can continue to grind higher until more pronounced signs of slowdown appear. You’ve heard us say this before, but it bears repeating: the labor market is not a leading indicator. Jobs data is critical for understanding Fed policy, but it tells us much more about where we are today than about where we may be in the future. We are staying hyper-focused on transition indicators and on portfolio balance as a result. What does that mean? A benign economic backdrop is unambiguously good news, but it can be frustrating for investors who have felt “stuck” in the current environment – and with the same portfolio strategy implications – for more than a year. We agree that the U.S. economy has been on a plateau – but it’s one laden with investor opportunity in our view. For investors who can be tactical, we believe it makes sense to stay fully invested until clearer signs of slowdown occur. Our two key indicators are consistent increases in U.S. jobless claims and a deterioration in corporate earnings expectations. Neither are happening in a meaningful way – yet. That said, there is far more that a benign #economic and #credit backdrop can do for investors. Those concerned about equity valuations can consider taking equity-like risk in high yield credit, where carry is more attractive. They can use small and mid-cap growth companies and #infrastructure equity to rebalance equity risk towards structural themes (i.e. digitization, electrification). They can also consider leveraging diverging economic cycles to add international equity exposure. 

🔻 The consumer is blinking This morning’s #retail sales data reinforced a message: the US economy is softening. Retail sales were weak in nominal terms and negative in real volumes, pointing to consumers pulling back as price sensitivity rises. The pattern remains K-shaped: higher-income households continue to spend, while middle- and lower-income families are becoming visibly more cautious heading into the holiday season. 📉 Margin pressure is building The producer price index (PPI) indicated wholesalers and retailers are increasingly eating tariff-driven cost increases to hold the line on prices. This margin squeeze is subtle but real—and likely to intensify as demand cools further. 😟 Expectations are sliding toward decade lows Consumer psychology is deteriorating. The Conference Board index fell to 88.7, with expectations dropping to 63.2—a level now flirting with its lowest readings in a decade. Households are concerned about weaker prospects for jobs and income, with inflation, tariffs, and politics amplifying the uncertainty. ⚠️ Early labor signals aren’t reassuring The ADP private payroll weekly pulse is still a young indicator, but directionally it points toward emerging job losses as we approach year-end. That aligns with a broader narrative: the labor market is cooling more materially than headline data imply. 🏛️ For the Fed, today’s mix argues for easing—but it will be a very close call. Labor-market softness is becoming more visible, consumer caution is firming, and inflation pressures are uneven across sectors. Taken together, the macro environment is shifting toward one where a rate cut would be optimal to cushion the downside risks to employment. However, the decision in December will hinge on how Chair Powell balances downside risks to employment against upside risks to inflation.

Do’s & Dots The Federal Reserve concludes its two-day meeting today, with markets virtually certain that rates will remain unchanged in the 4.25% - 4.50% range—marking the seventh consecutive month at this level. While the rate decision itself holds no surprises, traders are positioning for nuance. Bloomberg reports that savvy investors have taken long positions, anticipating Chair Powell will adopt a more dovish tone that signals future rate cuts. The real risk lies in the updated dot plot projections. A hawkish shift showing fewer anticipated cuts would likely disappoint both Fed watchers and markets, potentially triggering volatility despite the expected rate hold. Economic fundamentals suggest the Fed will eventually ease policy as growth moderates in the second half of 2025, down from the current 2% pace. The recession narrative has largely faded, with even previously bearish economists revising their outlooks upward. This shift reflects underlying economic resilience that has surprised many forecasters throughout the cycle. For the latter half of 2025, expect GDP growth to decelerate to a more sustainable 1% - 1.5% range—a pace that should provide the Fed with sufficient justification to begin cutting rates without signaling economic distress. When the Fed does resume its easing path, I expect: - Treasury rates to decline approximately 50 basis points over that year, with short-term yields leading the decline as the market prices in policy normalization. - Refinancing activity to accelerate across high-yield and broadly syndicated loan markets as credit spreads tighten and all-in borrowing costs fall. - Corporate earnings growth to initially slow alongside GDP deceleration, then recover modestly once Fed easing begins to support economic activity. - M&A activity to rebound significantly as companies that have been hoarding cash and preserving liquidity regain confidence to deploy capital. - Capital expenditure to increase meaningfully—a long-overdue development that's critically needed. - Housing market activity to strengthen as lower mortgage rates improve affordability and unlock pent-up demand. - Financial and technology sectors to outperform given their sensitivity to funding costs. - Credit market conditions to improve broadly, driving increased demand for private credit while reducing default risks across industry sectors.

These days, you don’t need to look further than the stock market for your daily dose of cortisol. Today was one of the Fed’s eight annual meetings, where Jerome Powell plays head chef and the market anxiously waits to see what’s on the fiscal menu (spoiler: it’s always hoping for rate cuts). So, what did Powell serve up? ❌ No cuts. Rates hold at 4.25%-4.5%. 📉 Growth revised down. 2025 GDP forecast slashed to 1.7% from 2.1%. 📈 Inflation revised up. Now at 2.7% vs. 2.5% prior. This should have been a net negative for markets - slower growth, higher inflation, no immediate relief. Then why did the stock market rally? Because macro is all about reading between the lines and disappointment is relative. ▪️No cuts ≠ No cuts ever. The worst-case scenario was Powell coming out and saying inflation is too sticky, and cuts are off the table for 2025. That didn’t happen. Instead, he played the patience game, which investors took as a sign that cuts are still coming - just not yet. ▪️ Less aggressive tightening. The Fed announced it will slow the pace of its balance sheet runoff, meaning more liquidity stays in the system. More liquidity means more support for asset prices. ▪️ Expectations vs. reality. Markets were bracing for worse. The fact that Powell didn’t sound more hawkish? A relief rally. ▪️ Slower growth = more pressure to cut later. The worse the economy looks, the sooner the Fed will be forced to act. So, ironically, bad news today makes future rate cuts more likely. Today’s rally is all about optimism that rate cuts are still in play, liquidity won’t dry up as fast, and Powell is keeping his options open. At some point, something will have to give. Will it be the Fed’s commitment to higher-for-longer, or the market’s faith in eventual rate cuts? The next few months will tell us who blinks first.

July’s employment report from the Bureau of Labor Statistics should give the Fed the exclamation point they have been looking for to show that the economy is slowing enough to warrant a rate cut. Market expectations have shifted firmly to a 50-bps interest rate cut at the Fed’s meeting in mid-September, rather than a 25-bps cut which had been the prevailing view prior to this report. Now handwringing will ratchet higher as to whether the Fed is in the process of successfully orchestrating a soft landing or if they have waited too long to shift their monetary policy stance. Job growth slowed more than expected in July and gains in May and June were revised lower. The unemployment rate increased 20 bps during the month and is up 60 bps over the past six months – unemployment rate changes of 50 bps or more over a six-month period have typically corresponded with recessions (see accompanying chart). Wage growth also appears to have slowed over the past couple of months. Even allowing for some volatility in the monthly data, the three-month moving average in employment growth and unemployment show an undeniable softening. Unemployment insurance claims add further evidence to the slowing trend. Initial unemployment claims have ticked higher over the past three weeks and continuing claims are at their highest level since the fourth quarter of 2021. It is difficult to call current labor market conditions weak with the unemployment rate still at 4.3%, but job gains appear increasingly lackluster across major employment sectors and the loss of momentum is undeniable. Stock and bond market participants are reacting in a way that suggests increased recession fears. Earnings reports have only fueled these concerns. The 10-year Treasury rate has fallen materially below 4.0%. Mortgage rates have also been ticking lower, which is good news for prospective home buyers. Rate cuts appear to be on the way, but macroeconomic conditions are increasingly precarious and the Fed’s September meeting may start to feel like a lifetime away if more bad news unfolds. The week ahead is not a busy one from an economic news perspective, but ISM services, mortgage delinquency, Fed Senior Loan Office Survey, and jobless claims, among others will be interesting to watch for additional information on the economy’s trajectory. What indicators are you watching for?