FAQs on the Markets and Economy
What is the federal funds futures market telling us about future Fed activity?
The December contract of federal funds futures market is currently pricing in a total of 50 bps in cuts this year. In the past year, expectations have swung from 50 bps in hikes (last autumn) to 75 bps in cuts (a few weeks ago) (see chart).
The movement in the past few months has been aggressively dovish with a 100% expectation of a 25 bps cut in the funds rate at the upcoming FOMC meeting on July 31. There was an outside possibility of the Fed cutting 50 bps at that meeting. This dovish view was brought on by the low level of inflation (1.6%), slowing global economy, increased trade tensions, and a weak labor report in May.
There has been a recent partial reversal in this view. Trade concerns have been tamed, fears of a trade war with Mexico are now gone, and there has been a resumption of trade conversation with China. Also, the payroll report for June shows the economy is not as weak as what was believed last month.
At City National Rochdale, we believe the earliest the Fed would lower rates is September. We believe the Fed wants to wait for more economic data and wants more time to measure the progress of trade negotiations before making a decision on changes to the overnight rate.
What did we learn from the recent labor report?
The June labor report was solid with gains in nonfarm payrolls leaping 224,000, much stronger than the 72,000 gain in May.
The monthly gain in jobs has been volatile this year, with a low of 56,000 and a high of 312,000, so we look at average gains to give us an idea of trends (chart). Clearly job growth this year is slower than last year, but last year’s growth was against the trend of the previous few years. Last year’s growth got juiced by the large corporate tax cut.
The longer-term trend in job growth has been slowing (arrow), a product of an aging expansion and difficulty in finding qualified workers.
The unemployment rate nudged up to 3.7%, from 3.6%. This happened for a “good” reason, with a 335,000 surge in the labor force.
What is happening to the yield curve?
The traditional view of the yield curve, the variance between the federal funds rate and the ten-year treasury note, has been inverted since late May.
Most of the inversion has been driven by very low inflation expectations and slower economic growth ahead.
The interest rate of the three-year treasury note is the lowest of the benchmark issues (chart). The yield fell significantly following the increase in trade tensions.
Although the economy is doing fine (unemployment rate at 50-year lows, low and stable unemployment), there is a growing expectation of the Fed cutting the federal funds rate to help ensure the expansion will continue for a longer period of time. That is what is driving demand for maturities in the next few years, so investors can lock in yields.
Is the outlook for stocks still positive?
We continue to have enough confidence in the economic outlook and see sufficient scope for earnings growth, to remain positive on U.S. Equites.
For now, U.S. stocks are have rallied back to record highs on optimism over potential Fed rate cuts, as well over a resumption in U.S.-China trade negotiations and the suspension of new tariffs. However, we don’t expect the pace of recent gains to continue. With markets now fully pricing in these positive developments, downside risks have increased somewhat and we expect volatility to remain elevated.
The U.S. economic expansion is in its later stage, the global economy is slowing, and trade policy remains a significant concern. As a result, profit growth is becoming more challenging. City National Rochdale continues to be focused on higher quality and dividend-paying domestic companies, while minimizing exposure to cyclical and export-oriented sectors most affected by trade concerns and global headwinds.
Over time, we think the bull market will continue and that stock prices will move up in-line with modest earnings growth. However, we expect the market will likely be range-bound and volatile until we get more clarity on trade and the path of interest rates. A consolidation period or another pullback is also possible.
What is City National Rochdale’s investment outlook?
Given our continued positive assessment of the fundamental backdrop, we remain positive on equities in general and continue to see attractive prospects in the opportunistic fixed income class.
Still, downside risks have increased somewhat and the investment landscape is growing more challenging.
Late cycle conditions of slowing growth and greater vulnerability to policy missteps will require investors to change their approach and be more selective in their portfolios.
None of this means there are not more opportunities ahead for investors, but gains are likely to be more muted. At the same time, concerns over global growth, trade tensions, and the path of interest rates mean markets will likely continue to be subject to periodic swings in sentiment and potential pullbacks.
Our equity and fixed income research teams have made deliberate risk-mitigating changes to help fortify client portfolios against the type of market turbulence we have recently experienced, while leaving them well-positioned to take advantage of opportunities that present themselves.