by John Lynch, Chief Investment Officer, & Team, Comerica Wealth Management
After a soft inflation reading in May, the Federal Reserve reduced rate cut projections for this year. Stocks and bonds rallied, choosing to ignore the message from monetary officials.
Executive Summary
- The Consumer Price Index (CPI) report for May, which was released only hours before the FOMC decision, revealed that both headline and core inflation cooled more than forecast. Headline inflation slowed to 3.3% from a year earlier and was flat from the prior month.
- As widely anticipated, the Fed left interest rates unchanged during last week’s FOMC meeting. Fed Funds Futures markets have largely brushed off the Fed’s hawkish projections. The markets are now pricing in two cuts this year, adding roughly 1/2 cut from the week prior.
- The yield on the 10-year Treasury note fell ~25 basis points over the course of the past week. We are closely monitoring the yield on the 10-year as reductions in this benchmark rate often act as a “pseudo-Fed cut,” easing financial conditions for loans and risk assets.
While election-related headlines may grab investors’ attention this summer, we will be focusing on fundamentals including inflation, earnings and interest rates when positioning our clients’ diversified portfolios.
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Inflation
The Consumer Price Index (CPI) report for May, which was released only hours before the FOMC decision, revealed that both headline and core inflation cooled more than forecast. Headline inflation slowed to 3.3% from a year earlier and was flat from the prior month. The biggest improvement came from energy prices, which declined due to demand concerns. Core CPI, which excludes the volatile food and energy components, slowed to 3.4% annually, its lowest reading since mid-2021. See chart: Consumer Price Index (CPI).
The last two CPI reports appear to show the disinflationary trend is resuming, giving credence to the idea that the setbacks to start the year were just seasonality effects, as companies typically try to raise prices early to see if they will stick.
Federal Reserve
As widely anticipated, the Fed left interest rates unchanged during last week’s FOMC meeting. However, new economic projections reveal a higher inflation forecast with monetary officials now expecting only one rate cut this year, compared to three cuts forecasted in March. The updated forecasts reflect the higher-than-expected inflation readings during the first quarter of the year, most of which was released after the Fed’s March projections.
It is difficult to determine the extent to which Fed members incorporated the latest CPI report into their projections. Fed Charmain Jerome Powell indicated that members had the ability to adjust their forecasts following the release of the CPI report but also noted that very few did so. Fed Funds Futures markets have largely brushed off the Fed’s hawkish projections. The markets are now pricing in two cuts this year, adding roughly 1/2 cut from the week prior. See chart: Fed Funds Futures Implied Rate Cuts in 2024.
We suspect it may be challenging, though, to make significant progress on the annual rate of inflation during the second half of this year. The month-over-month inflation data was slow from May through December last year, increasing by an average monthly change of less than 0.2%. Since those months will be rolling off the annual inflation prints as new monthly data is released, the tougher comparisons could make it more difficult for the Fed to gauge progress on YOY price measures.
Fixed Income
Similar to fed funds futures, the bond market also discounted the Fed’s messaging. Indeed, the yield on the 10-year Treasury note fell ~25 basis points over the course of the week. We are closely monitoring the yield on the 10-year as reductions in this benchmark rate often act as a pseudo-Fed cut. Since this rate influences loan pricing for many parts of the economy, movements can have an immediate influence on financial conditions for borrowers in the real economy and also impact the discount rate for risk assets. A further move in the benchmark yield toward 4.0% could benefit stocks, assuming the driver isn’t fear of recession. See chart: U.S. 10-Year Treasury Yield.
Though equities rallied on the Fed’s statement, we continue to view the fixed income market cautiously. As we wrote in our Midyear Market Outlook, investors are encouraged to maintain diversified strategies while keeping interest rate sensitivity (duration) at benchmark levels and embracing credit quality. With this stance, we believe portfolios can benefit from elevated coupons while also mitigating the volatility associated with fears of geopolitics/recession (bond yields lower) and expanding federal deficits (bond yields higher).
While election-related headlines may grab investors’ attention this summer, we will be focusing on fundamentals including inflation and interest rates when positioning our clients’ diversified portfolios.
Be well and stay safe!
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