Webinar Replay

Fed Watch: The Process for Rate Cuts

January 31, 2024

During this Office Hours replay, you will hear from Professor Jeremy Siegel WisdomTree Senior Economist, Jeremy Schwartz Global Chief Investment Officer and Kevin Flanagan Head of Fixed Income Strategy who discuss the results of the January FOMC meeting. As part of this discussion, they focus on market expectations for Fed policy in 2024 and how investors should pivot for rate cuts.

This event was simulcast on Zoom.

Irene:

Hi everyone. Thank you for joining our Office Hours on Fed Watch: The Process for Rate Cuts where you'll hear from Professor Jeremy Siegel, WisdomTree Senior Economist, Jeremy Schwartz, WisdomTree's Global Chief Investment Officer, and Kevin Flanagan, WisdomTree's Head of Fixed Income Strategy.

 

Jeremy Schwartz:

Well, it's always great to be on with the professor, Kevin, post these Fed meetings. We get some real-time market reaction on the latest. The professor's been calling the Fed I'd say as well as anybody and has been critical of the Fed. Professor, what you're hearing now, how do you feel they're getting it on the inflation? What are you hearing? And how do you think the market responded versus what you think it should have done?

 

Professor Siegel:

Okay, so it was interesting. Market was doing okay until he said, "I don't think it's likely that we will cut in March, but it remains to be seen." And immediately everybody's, "Oh, he's not cutting in March." And the first thing I said is, "Well, last Saturday, I would say 90% of football gurus said it was not likely that Kansas City Chiefs would beat the Baltimore Ravens, but it's yet to be seen." And in fact they did. The truth of the matter is that it's going to be totally data dependent.

Now, with that said, what encouraged me about the Fed meeting was how much he did stress the conditions of the labor market would be a reason to cut. In fact, he said, "Weakening of the labor market is reason to cut." He said that twice. He said also, "I would cut earlier if we had a really big downward movement of inflation that was unanticipated even with the stronger labor market." But he twice said that a weakening of the labor market was sufficient for him to get the cutting process started.

He also, of course, seemed to be badgered by a number of reporters, including Nick Timiraos of The New York Times who's been writing he's going to reduce it in March, and I guess has some egg on his face if they don't. They've met most of their criteria and when are they going to start? I think, and this is something that I've been saying and I've been saying in our weekly forecast, that it's the strength of the economy. The economy has been holding up over these strong real rates. Listen, the Fed is smiling from ear to ear. It couldn't have things better. After terribly messing up the inflation itself from the beginning, they've tightened to the point where they have slowed the economy to be sure and the inflationary process, but not killed the economy. So they're pleased as a bee now about where they are and no particular pressure to lower early.

However, again, you know what we look at, we look at jobless claims, they did jump last week, but into a more normal range. You have this problem, this regional bank that reported bad earnings. I don't think there's anything lurking out there. It was interesting, that was not brought up and yet it definitely really affected the market in the early morning about are regional banks in good shape. I was surprised there was really no question on that.

On the quantitative tightening, this was, I thought, good news. He said, "Very definitely we're talking about it March, whether to slow it down or not, but it all depends on what kind of data we get." We going to get a lot of data between now and March. Of course we get the January employment report Friday, we're going to get then the February employment report, we're going to get two big inflation reports and a lot of data. So it's another seven weeks, eight weeks until the Fed meeting.

So there's going to be a lot of data and that's going to basically dictate. I say if you see a weakening and if you see that employment rate and move up to 3.9%, particularly 4.0%, which is a psychological limit that gets hit. We haven't been there for a long time. I think a March cut is very likely. Do I want to see that as a stockholder? Not really. Do I want to see a big weakening of the economy so oh yes, they're going to cut rates? It's almost like you're cheering for economic weakness so they can cut rates. That's more important than the earnings implications of the economic weakness, which is a silly way to think about things. Now I do think that the real rate has to come down. I think the term structure has to un-invert. I do think the normal Fed funds rate is closer to 3.5%, not 2.5% like I said because I think the real natural rate has risen. We've talked about this on our weekly program.

It is interesting. He was asked the question about the natural rate and he seemed to imply, although it wasn't explicit, that he doesn't particularly think the natural rate has risen, which means he still thinks that 2.5% is the long-term fed funds target. In other words, the real rate being a half a percent, 2% inflation giving you that 2.5% nominal fed funds target. Well, he's more than twice that level right now, so he should realize how tight he is. If he thinks that the economy is that close to being in balance, he's really tight. I think that real rate has risen to at least 1.5%. I might even be persuaded maybe even 1.5%, maybe even 2%. But I think at this particular time, at least 1.5%, which would give us 3.5% short rate. Long rate being around 4%, exactly where it is today, that would be a long run.

So I would say I was net encouraged QT discussion March. I'm going to look at employment very carefully in judging slowing rates. He didn't say, "Oh no, I don't care about employment as long as inflation stays high." I mean, that was the big danger. Absolutely did not say that. It is true that there's a lot of hawks on the committee and many of them voting now, Loretta Mester and others. So he didn't hear a lot about, well, we got to cut rates by March, but that can turn on a dime. One bad employment report, a couple of weak reports, any other ripples in the financial market and it can turn 180 degrees as soon as you can say the Fed. So remember, saying, "I don't think it's likely, but remains to be seen", is in no way a commitment that he will not cut rates if necessary.

 

Jeremy Schwartz:

Professor, you've talked about this real rate a few times and the sort of function of a few variables, one being productivity and another being sort of the rising correlation between stocks and bonds. As you think about that, is it more the productivity, real growth being higher, meaning higher real interest rates? Or how much is that correlation factor?

 

Professor Siegel:

Well, that would definitely be true on the longer end. It's a little harder on the shorter end, but I do think there's feedback there. But we have faster GDP growth. Now it's also very interesting, now he did mention AI and he didn't think it was going to have much of a short-term effect. He said it may have a long-term effect. He was talking about productivity. He actually went through the scenario, big jump two months right after the pandemic and then it went into a terrible slump in 2022. Came back in 2023. He didn't think it was permanently higher, but it's not his level of expertise necessarily.

He opened the door saying it could have long-run implications. I do think it has implications. I've talked to 50 to 75 basis points of extra GDP growth, productivity growth, that would raise that rate. So I would say maybe half to 2/3 of it is the higher growth and maybe 1/3 of it is the worst correlation. The longer run, I think that the worst correlation between stock and bonds in the future is probably more important to raising that long rate definitely, because you're looking at those long-term instruments than it is on the short end.

 

Kevin Flanagan:

Professor, one of the questions we receive a lot has been, can you characterize what is a weak employment report? What exactly would you say if the number comes out on Friday, does it have to be payrolls below 100? Does it have to be negative hours worked? What would you define as a weak employment report?

 

Professor Siegel:

Well, don't forget, and there's also what is really weak and what is politically weak or headline weak. If you got a negative report, that just would hit the headlines. Front page papers of not just Wall Street Journal and Financial. First negative report in I don't know how many years, oh my God, losing jobs. I also think the unemployment rate, if it jumps to 4% is a psychological level. Now it's 3.7% now, it had gotten up to 3.9%, then back down. I don't think it's getting maybe 3.8% tomorrow. There's expected to be modest job growth. ADP today was a little low, but that correlation has not been great recently. Yeah, under 100 would be low, but negative would grab headlines. Negative would grab such headlines. The story of, "Oh, Biden administration, the economy is good", would say, "Oh my God, we're losing jobs for the first time in three years." All the political people will weigh in on that and Powell's going to get some phone calls.

So really that's the political weak. There's really not much difference between let's say plus 50,000 and minus 50,000. But there's a huge... I mean not much economic difference, but there's a huge political difference if it turns negative. Hours worked is something I've talked about, but no one else does. So if it's at a post-pandemic low, if it drops below that low, that means effectively less workers, but GDP looks okay this quarter again, which means it's just the rise of productivity. So hours worked is not going to have really very much impact at all as long as the real economy looks like it is still producing goods and services, then it's got to be basically productivity that's feeding that difference.

 

Kevin Flanagan:

Do you assign any kind of importance, the fact that they dropped the reference to the banking financial institutions and-

 

Professor Siegel:

Yeah, I found it interesting.

 

Kevin Flanagan:

... financial conditions?

 

Professor Siegel:

... interesting on the day that we got a little bit of a ripple. Don't forget they did that report before that little ripple came out on that. I think it's basically right though. I mean, who was it, Sternlicht who said there's a trillion... what did he say? $1.2 trillion of commercial real estate wiped out. Yeah, that's factored in. I mean, compared to the wealth of the US economy, that's what, 2%, and that's the in. I mean, I honestly don't think... Now a recession itself will strain balance sheets and obviously if you have a lot of commercial exposure, then you're going to be in trouble. But that alone, without a significant weakening in the economy, I do think that danger has passed.

 

Jeremy Schwartz:

Related to all this bank lending and the bank issues has been some of your commentary on the money supply. I mean, you one that has said the money supply is one of the key drivers of inflation. It hasn't been growing at the 5% you would like. Is that-

 

Professor Siegel:

However, I don't know, Jeremy, if you looked at... See, I look at weekly deposits. We only get an M2 every month, but we get weekly deposits. Guess what? Get every Tuesday and it's broken out of its range on the upside. It's now the downside that it reached last March during the SVB financial problems, it was flat, and now has started upward. That's encouraging to me. I think they've got to lower rates to continue it upwards because you get money supplied by people taking out loans. That's how banks create money. So I think they're going to have to lower that rate to keep that rising. But I've been a little bit encouraged... Well, again, you haven't seen it so much in M2. It did rise last month, but the weekly ones have been looking a little encouraging from this point so far.

 

Kevin Flanagan:

Professor, are you still in the US Treasury 10-year 4% representing fair value?

 

Professor Siegel:

Yeah. I think, 3.5% funds, that would be 1.5% natural rate our star and a 50 basis point premium, which is a little lower than normal. I could see 4% to 4.5%, it depends on how much the people start liking treasuries because they are hedges... Remember, treasuries are great hedge against every risk except inflation risk. And so if inflation risk is reduced, then it's geopolitical risk, it's virus risk, pandemic risk, financial risks, all those risks, those treasuries are great. They went up in every one of those crises. So again, it's the play, more inflation risks, higher the treasuries, less inflation risk, lower the treasuries. So we'll see how that goes. So I can see it basically at 50 basis points long run.

I also found it interesting, it's something I've looked at and Gundlach was on CNBC, he's their main commentator right after the meetings and, I mean, I don't agree to his views. He's been thinking there's going to be a hard landing for quite a while. Well, I worried about that, but then last July began to see how strong the economy was and said, Hey, this is working better than everyone had feared, including the Fed. But he's more of an expert on credit than I am. And probably you might want to speak to this Kevin, but he thinks credit is way overblown right now. Now maybe because he thinks it's a recession is on there, but he thinks credit from junk bonds to everything else is high at the current time and that everyone wants it and it's a crowded trade. I don't know. It's certainly risen up dramatically from last October when people were really fearing a recession much more than they are right now.

 

Kevin Flanagan:

I mean I would like to see spreads a little wider from here for us high yield, investment grade to some extent, but more on the high yield side. I wouldn't say that it's as dire perhaps as Gundlach is saying at this stage of the game. We actually have some work we've done internally looking at a horizon analysis with rates and spreads and say a worst case scenario spreads move out a hundred basis points, rates rise from here. And the cushion that you have from getting 7.5%, 8% yield, bonds are math. That's what I always was taught, bonds are math. Is that you still can eke out positive returns in high yield based upon some of those current yield levels that exist right now. So I understand if you're looking or just focusing on spreads, and I think a lot of it probably does have to do with what you mentioned, Professor. If you're looking for a hard landing then high yield at these spread levels is probably not somewhere you want to be right now.

 

Professor Siegel:

Yeah. Again, I don't have a real feeling about that. I guess the only feeling I have is I think soft landing is at least two to one, and by that I mean no negative GDP print or certainly no two negative GDP prints, which is sort of an informal recession definition, although we did have that a couple of years ago and they didn't call recession. But credit is usually good if you don't have the recession.

So again, my biggest takeaway as I listened to him was twice he strongly mentioned that a weakening of economic conditions would be a reason for him to accelerate cuts. That's what we wanted. That's what the market heard in December. And again, I emphasize the biggest worry of the market was that Chairman Powell was going to be as stubborn on the way down as he was on the way up. That would be a disaster. He has signaled continuously since late last year that that won't be the case or he does not intend that to be the case. And nothing that I heard today changed that.

Remember he said, "Based on the discussion we had today, it's unlikely that we will cut in March, although it remains to be seen." Again, there's two things that's not precluding March and the Fed has no special crystal ball that makes them so much of a better forecaster that they know either inflation will flare up or something else will prevent them from dropping rates. They don't. So as a result, they are basically going to be moved by the data, as he said, totally data dependent. And the data, as I said in our Friday programs, I said, the data's coming in strong, they're smiling ear to ear. There's no reason for them to say, hey, show me why I have to lower it right away. Do we see any weakening? Yes, maybe I should be preemptive, but until I actually see a weakening that the economy can't take these real rates, and I'll be as preemptive as I can, I'm in no rush.

 

Jeremy Schwartz:

Kevin, we talked a little bit about the positioning of the professor thinking 4% is around fair value for the 10-year and that has you in some of our model portfolios we run staying short duration the benchmarks. Professor, for equities, I've heard you talk about tech versus non-tech and small caps and part of the upgrading of the economy, lowering probability of recession. In the model portfolios we worked on with you, we upgraded small caps, particularly with quality as an emphasis. I think some of the regional bank stuff, even just you saw today, you're underweight that when you have a quality filter is one of the things that we... we have small cap value, but with this quality filter, is anything you've seen with earnings season, anything has you less... I mean today you had a big tech versus non-tech rotation.

Professor Siegel:

I thought what was really interesting, let's say yesterday was Microsoft and Alphabet and AMD all beat, I think both their earnings and their revenues and went down. Starbucks missed its revenues and earnings and went up. Now what does that tell you? It tells you how high expectations are in the tech sector, that it's not just enough to beat, you got to beat by a lot. In fact, we've seen how they're marked down. I mean, they're really just marked down how much they went up over. Everyone said, "Oh, their earnings are going to be great by them before their earnings." It's sort of like Bitcoin, "Oh, once ETF comes out, it's going to shoot up. Buy it before then." I mean that seems to be what had happened. I mean, they've given up just to gain. They're not at any sort of lows of any say what, a two-week lows or three. They're not at any really lows, but it just shows you that they depend on continuingly outrunning official.

If you're a tech company, you're selling for 30 times earnings, 35, 40, whatever, you've got to beat expectations or you're going to go down. That's always going to be it. Now, they've done it over two or three years, but will they always do it? I've always said I want to own a 10 PE stock that always makes its earnings and doesn't have to grow at all, don't shrink, but don't have to grow. I'll get a 10% real yield on that and I'll beat any NASDAQ or tech average you have. So you don't need the earnings growths, you don't need earnings growth when you have low PE. So those are just basic facts of finance and I still believe them to be true. Now, the fact is that some of the small stocks have lost earnings, and as I said, on the whole, maybe not this quarter, but on the whole, tech has surpassed its expectation to continue its upward momentum. But does that happen forever? Well, history suggests not.

 

Kevin Flanagan:

Another question professor comes in, is there a disconnect on inflation or how we think about inflation between Wall Street and Main Street? So Wall Street has been applauding the continued decline CPI. Powell mentioning today, like you said, nice big smile on his face probably. But then when the conversation's turned and you see it a lot since we've started primary season, when people are being interviewed, say "on Main Street," they're still talking about higher prices. Do you think there's a disconnect there?

 

Professor Siegel:

Well, actually I think Powell had it right. If you listen to him, he said, what they're angry at is that prices are up 10%, 12% more than they would've been had they stayed on the inflation path that they were until the pandemic. That's a loss of purchasing power. Now, wages have barely kept up, so our wage price are virtually unchanged over four years. That's not a great performance. That's not great. That's that's bad historically. And again, if you're not a homeowner, it's worse. Trying to buy your home now, it's 136% up cost of home and financing. There's a lot of people left out.

The average person, first off, the average person doesn't know the difference between levels and rates of change. Inflation, I see higher prices, inflation could be zero. I see higher prices and my wages may or may not have gone up. I mean, half the people have and half the people haven't met that wages. And that's what they see. And then there's also the psychological thing. Don't forget when they get a wage increase, they think it's due to them, and if they get a price increase, then the government's stealing back from them. I mean, rather than connecting the fact, the only reason you got a wage increase is because prices actually did increase.

So those are the real factors at work. I mean some of them are real, some of them I relate to the psychology that has always been present of why people think that inflation robs them of purchasing power even if their wages barely keep up and they barely have kept up. So yeah, we're cheering the fact that... And don't forget the goal of the Fed, it's not to get prices down to pre-pandemic levels. It's just to get the rate of change back to the 2%. We're always going to have that 10%, 12% wedge that he produced by excessive monetary expansion over the '20 to '22 year period, that two year period, 2020 to 2022. I mean, that's always going to be there. Some people think the Fed should bring the economy so prices are back down to where they were. Or on a glide path that goes back to the 2% rate. Well, that's not going to happen either and that's not the goal of the Fed. It's water over the dam, it's mistakes that were made. From here we go to 2% and that wedge is always going to be there in the data.

 

Kevin Flanagan:

That's a great point.

 

Jeremy Schwartz:

There's a few questions just on model portfolios and how much fixed income. We encourage you if you're interested in more customized follow-ups, our model team is happy to work with you all. If you have questions on what's appropriate, please get in touch. We do a lot of custom portfolio work. Professor, but on a broad basis of the 60/40 versus 75/25, any shifting is your view of what's the more ideal portfolio, let's say for that sort of moderate growth investor who tended to be 60/40, for while we've been saying 75/25, how are you...?

 

Professor Siegel:

Well, when we were saying 75/25 before the pandemic, which was definitely right, and had you filed that, you would've been much better off. Now, right now with real rates up people saying, "Well, what do you expect?" But right now the 10-year TIPS is 1.7%, a 20 PE is a 5% earnings yield. So it's, what is it? It's a 3.3% advantage of stocks over bonds per year and stocks have that inflation hedge long term where bonds don't, unless you go TIPS-wise. I still absolutely think that 75/25 is going to be a better risk-return portfolio for you long-term than a 60/40.

 

Jeremy Schwartz:

Very good. Any closing thoughts, Kevin? From your side on the fixed income duration side? Anything you would add?

 

Kevin Flanagan:

No, I mean just sticking it to the models in terms of positioning, what we had done towards the