Join us to see Garrett Melson, portfolio strategist at Natixis Investment Managers Solutions, offers insight into the Federal Open Market Committee's decision and gives his predictions for monetary policy, including when he sees the Fed cutting its rate target.
Transcription:
Transcripts are generated using a combination of speech recognition software and human transcribers, and may contain errors. Please check the corresponding audio for the authoritative record.
Lynne Funk (00:09):
Hi everyone. Welcome to another Bond Buyer Leaders Forum event. I'm your host today, Bond Buyer executive editor Lynne Funk. I am subbing in for my colleague Gary Siegel, who is under the weather today. So our guest today is Garrett Melson, portfolio strategist at Natixis Investment Managers Solutions. Garrett, welcome and thank you for joining us.
Garrett Melson (00:34):
Thanks for having me. Happy to be here.
Lynne Funk (00:36):
Great go easy on me today.
Garrett Melson (00:39):
I'll do that.
Lynne Funk (00:42):
So today we're going to be talking about monetary policy including yesterday's FOMC committee meeting. So the first question out of the gate is, was there anything in the statement or Powell's press conference that surprised you or maybe grabbed your attention?
Garrett Melson (00:59):
Yeah, so I'd say there's a couple things. Starting with the statement, there are obviously a number of pretty substantial changes. Ironically, on the day that we got some more fears emanating from the banking sector on the New York Community Bancorp earnings release, they actually removed that statement that acknowledged the health and resilience of the banking system. So a little irony there, and that I think was kind of setting the stage for some of the market action entering the meeting. But outside of that, we certainly expected to see that tightening bias removed. It was so we no longer have that hawkish bias, but I think the biggest one was how that language was replaced and it was a little bit unclear. And to be honest, I think the knee jerk reaction was a little bit of a hawkish surprise. So this idea that they're not quite convinced that inflation's durably moving back to target, but when you read it a little bit closer, I'm not quite sure it's as hawkish as the initial reactions suggest.
(01:56)
It's somewhat of a toothless statement. They already have some confidence of inflation moving back to target. They just need a little greater confidence before they begin easing. And I think that's kind of the takeaway from the presser. It was kind of a buried leave. It took about 30 minutes in and until Powell acknowledged that March was probably not going to be where they start to cut rates because they're not going to have sufficient conviction in terms of that durable move back to target. But I think what's really kind of shined through is the fear of some of these CPI revisions and I think that's what's really holding them back. It's a theme that we heard from Waller over the last couple of weeks, this seasonal adjustment revisions that we get every single year for CPI, we had a big head fake last year. So a lot of the trends of disinflation for the back half of 2022 basically evaporated with those revisions. And I think they're a little bit fearful of getting caught flatfooted with another repeat of some revisions like that. I don't think they necessarily expect it, but I think that's part of why they're a little hesitant to lean into validating marches that first cut. So I think that's the big takeaways. The tightening bias is gone now. It's just a matter of stringing together more evidence of that lower trend of inflation that we've really set into place over the last six or seven months.
Lynne Funk (03:13):
So the Fed won't commit to when its first rate cut will be, we know it's not going to be March. So what's your base case?
Garrett Melson (03:20):
So our base case has been May for quite some time. That said, I still think there's actually a little bit of residual odds that March is the first meeting. And the reason for that is if those revisions are fairly benign, we're going to get two more CPI prints and essentially a look at PCE, which remember that's what the 2% target's really referring to. And there's been a big wedge that's really grown between CPI and PCE. So when you look at PCE, it's a lot more encouraging here. And if those revisions are benign, I think you're going to have some pretty clear evidence that we're really approaching pretty rapidly that 2% target. And I think even we'd have some evidence that we might undershoot their full year expectations for where PCE closes 2024. So I'd say it's not fully a done deal that marches off the table, but for now our base case has been and it remains that may will be the first rate cut.
Lynne Funk (04:15):
Okay. And how many cuts do you expect this year?
Garrett Melson (04:20):
Again, I think we're fairly close to what the Fed has been saying and that's probably three to four cuts and I think that's probably going to be front loaded. So if they lift or they start that first cut in May, then I would expect you probably get a sequence of those cuts. So May, June, July, and then maybe pause to see how the data comes in from there. And maybe an incremental cut towards the end of the year if data continues to kind of settle down towards target and growth is holding up and labor markets aren't falling apart. So three to four cuts is our base case now. I think this kind of gets into an interesting dynamic of what's the market pricing versus what the Fed is pricing. I don't think there's a huge disconnect there when you look at really what the modal outcome is. It's basically pricing all the potential outcomes. But I think the base case for the market and from our perspective is right around that three to four cuts.
Lynne Funk (05:11):
Okay. So when you look at the SEP, it showed a big divide on opinions going forward, what do you think the implications are for monetary policy?
Garrett Melson (05:22):
Yeah, so somewhat have a love hate relationship with the SEP, I think it's more useful to look at it as a messaging tool. And so they're going to lay out basically their reaction function and use it as a tool to push the narrative that they want and the rhetoric that they want. That said, we've gotten some pretty significant shifts from quarterly meeting to the next over the last year or so. And basically when you look back at that September meeting, that kind of looks like the anomaly, the most recent SEP looks a whole lot like it did back in June. And so I think the point you get to where there's quite a bit of dispersion in terms of expectations over the longer run speaks to a lot of the uncertainty in the outcomes from a growth and inflation dynamic. But over the short run, I think that the bigger picture is they've laid out the case that they expect inflation core inflation to settle back down to about 2.4 by year end that's consistent with three cuts.
(06:18)
And then by end of 2025, essentially seven cuts are consistent with getting back down to 2.2. So they think it's going to take a long time to get back to 2%, but all along the way they expect that easing and recalibrating policy back to neutral is going to be warranted. And I think that's the bigger takeaway. We can argue about the exact number of cuts, but ultimately I think when you look at their projections, I think there's a strong case that the data actually improves, at least from an inflation perspective, it declines faster than market expectations as well as what's laid out in that SAP. And if that's the case, then the projections that are laid out from a policy rate perspective are no longer valid. And that would suggest potentially adding another cut into the forecast. And I think that's probably what we'll actually see come the March meeting with the revised SEP.
Lynne Funk (07:06):
Okay. So do you see a soft landing? Are you expecting a recession? If so, when? How long, how severe?
Garrett Melson (07:17):
Yeah, I mean that's been the big debate driving market action over the last year. Plus we've been firmly in the soft landing camp for that entire period. And to be honest, Powell has been as well, I know his rhetoric has shifted and he's gone from really leaning into the Volcker playbook, but more recently he's really leaning into the Greenspan playbook and explicitly targeting that mid nineties type soft landing dynamic. I think when you look at what's likely to play out in the data versus the market narrative, it's not surprising to us at all that you've seen these really sharp narrative oscillations and the market will gravitate and latch onto single data points and extrapolate that into the future. And we've seen that play out time and time again, whether that's going from basically a hard landing to a soft landing to a no landing, then back to a hard landing and then kind of around and around we go.
(08:11)
But I think the debate as to whether we're getting a soft landing or a hard landing, it's almost kind of over, right? I mean the Fed's not willing to declare victory yet, but when you take a look at the data, it basically speaks to a soft landing playing out. You have core inflation already trending under 2% over the last seven months. You have growth that continues to hold up. You have labor markets that are still strong, albeit modestly slowing here. I mean, that's basically all the check marks for a soft landing here. So yes, can things change over the next couple months and quarters, of course, but I think you can basically make a case that we're already accomplishing that soft landing here. And what I think is more important is if we're wrong in that and we start to see something break in the other direction and maybe some weakness start to emerge, we still see that there's some resilience in the labor markets.
(09:04)
And I think the starting point of where this economy is really matters. So if we start to see some weakness, you have to go back to the starting conditions for the economy, which is corporate balance sheets are very, very strong. Household balance sheets are rock solid, near multi-decade lows in terms of leverage. And if the labor market's broadly holding up well, if growth is really falling, inflation's cooling off and labor markets are showing a little bit of weakness, rates are going to be falling pretty dramatically. And that I think is going to unlock a pretty powerful countercyclical force in the housing market. We see how much demand is on the sidelines there. So again, we can still have some risks in either direction, but I think the tails are basically getting clipped off the distribution of how the economy unfolds from here, and that's clipping the tails of Fed policy as well. And that's ultimately I think, supportive for risk assets and risk appetite. So that's I think a big driver for how we see the market unfolding as we move through the year and ultimately we're still in that soft landing camp.
Lynne Funk (10:03):
Okay. Maybe I should ask this first, but maybe you already kind of answered this, but do you think the whole full impact of the past hikes has worked through the economy yet?
Garrett Melson (10:13):
Yeah, that's a really good debate as well. I'd say in very interest rate sensitive areas of the economy, you can see obviously in effect, and it kind of goes back to Milton Friedman's quote, the long and variable lags of policy that I still think is being debated, but I think increasingly you see evidence that those lags are pretty short and they're not all that variable. So when you look at the interest rate sense, the areas in the market housing basically ground to a halt immediately. And when you take a look at some of the investment decisions in the corporate sector, again, financial conditions tightened ahead of liftoff from the Fed, and so you basically saw that pricing in the markets ahead of time. So I'd argue that a lot of that tightening actually played through very rapidly, and that's part of the reason why we saw such a slowdown in growth in the early part of 2022 and why now we're actually seeing a reacceleration in growth that a lot of people didn't call for.
(11:06)
The other thing is I think policy has had some effect, but the bigger driver of growth and the slowing in inflation has just been the massive recovery in the supply side of the economy. And I think it's always hard to prove the counterfactual, right? Growth probably would've been hotter and inflation would've been stickier if we hadn't had tightening, but ultimately I think that's already kind of played through the economy and the economy is largely less rate sensitive than we give it credit for because of what I mentioned in terms of corporate and household balance sheets, they're very strong, they termed out debt low rates, and they're not as credit sensitive because this is more of an income driven cycle here. So yeah, I think it's had an effect, but I think the bigger story really is the rapid improvement in the supply side of the economy that we've seen over the course of this year, and that's been really the big driver for growth and inflation over the last 12 to 18 months.
Lynne Funk (12:02):
And is there any chance that if that the Fed would be late on making a first cut at all?
Garrett Melson (12:10):
Yeah, again, I think that kind of gets back to the same dynamics. I mean, I just don't think the policy backdrop matters as much as we want to think it does right now. And that goes back to that income driven cycle, right? It's not leverage and credit that's really fueling this expansion right now it's just outright income growth. And when you look at that, it's kind of a Goldilocks scenario, right? You're having normalization in the labor markets. Again, I'd say it's kind of a soft landing in the labor markets as a result you're having nominal wages falling, but because inflation is falling so much faster, that means real wages are actually growing meaningfully and that's helping to support consumption and support growth in the economy here. So it kind of goes back to the debate that's raging and there's been plenty of ink spilled and breath wasted, and we're doing it here today again in terms of is it March?
(13:00)
Is it May, is it June? I don't think it really matters at the end of the day because the bigger picture is growth is holding up inflation is durably moving back down to Target, and there's a huge pipeline still yet to come to fruition, namely in housing and shelter costs. And the Fed is shifting from a tightening bias to an easing bias. And so they're clipping off those right and left tails of policy. And I think that's the bigger story here. So timing and the exact magnitude of cuts, plenty of debate will continue to rage on that, but I don't think it really matters as much. And that's why I think the risks of something of an overshoot or a policy mistake here aren't all that great right now just because the fundamentals are very strong.
Lynne Funk (13:43):
Okay. So you talked about labor, what about consumers? They're still spending it's propelling GDP at faster rates than a be expected. Do you see spending slowing? If not, what will be the reason for an economic slowdown?
Garrett Melson (13:59):
Yeah, I mean the adage goes, right, never bet against the US consumer, and that has been the case. So if you've been betting against them over the last 12 to 18 months, it's been a tough trade. I think consumption's going to remain pretty robust here. And again, it goes back to that dynamic in terms of real wage growth that has been increasing and that's really been driving consumption over the last couple of years here. So I think that's the big story. Consumers aren't rate sensitive, they're not as credit sensitive. Are there portions and segments of the population that are sure and that typically happens at the lower income bans and that's not abnormal for any sort of cycle. But from what we're seeing here, I'd actually argue that we're seeing a little bit of an increase in terms of some layoff announcements. What's interesting is a lot of that has been actually driven by restructuring and maybe trying to protect margins for corporates as opposed to just general poor macro conditions, which was a big driver of it last year.
(14:56)
But at the end of the day, you're still seeing that people that are looking for jobs are able to get it. Maybe that matching and hiring rate is a little bit cooler, but if growth continues to hold up and the fed is stepping back and inflation the problem continues to fade, well then the growth outlook is getting better. And you tend to see that cyclical employment and investment tracks that. And so that's going to just improve and increase the backdrop for the consumer to continue spending over the course of the year. So I think could we decelerate modestly from the robust pace of consumption over the last six months? But I don't really see that falling off a cliff here, but bigger picture, and not to take too much time on this, part of the reason we've been so constructive on the outlook for the economy has been the consumer, but there's been so many other tailwinds at play for the economy over the last 12 to 18 months.
(15:46)
Go back to fiscal policy, it's not so much fiscal spending, but that fiscal drag has gotten less and less and a drag on growth that's declining, getting smaller is a contributor to growth that's actually been playing out over the course of the last couple quarters. State and local government balances and revenues holding up very well. And you're seeing a lot of consumption, employment and expenditure coming from those areas of the economy. Go to the private sector, huge room for a comeback in terms of inventory and production for the auto sector, building back that massive inventory gap from where it is now to where it should be back to trends. Same thing goes in the aircraft sector. Obviously Boeing kind of in the headlines for negative reasons, but they have a massive order book over the next couple of years to a decade that's going to be an area of continued production and there's downstream or I should say upstream effects to their suppliers from that.
(16:41)
And then a couple others just to kind of take that dynamic a little bit more broadly. We've seen that excess inventory throughout manufacturers throughout retailers over the last couple of years, but a lot of that adjustment has already taken place and you're seeing a lot of signs. Just take a look at the ISM survey this morning. A lot of signs that customer and manufacturer and retail inventories are too low, and if consumption's holding up and inventories are too low, that means production needs to ramp up. That all kind of feeds into growth dynamics and I think those are all, there's more, I won't bore you with them, but I think that's all helpful to put a floor in for growth and has been a big reason why growth has really outperformed expectations that have really revolved around a hard landing and a recession for it feels like a couple years now.
Lynne Funk (17:30):
So digging back into recession, and when you look at historically, the yield curve when it's inverted, it's been inverted now for over a year, usually signals potential recession coming. So why does the economy continue to surprise forecasters and defy?
Garrett Melson (17:49):
Yeah, I mean part of it is some of those mechanical effects from those drivers and specific sectors and industries that I mentioned. The other part of it is everybody always has that kind of urge to find that silver bullet. So to call a recession, to call a pullback a bear market, and it just doesn't work that way otherwise I probably wouldn't be sitting here talking to you, I'd probably be sitting on the beach with a drink in my hands. But the yield curve, obviously it's got a pretty good track record, but just point back to 2019, right? It inverted and before the pandemic, it's again, hard to prove counterfactuals, but when you look at all the data leading into the early stages of 2020, it was reaccelerating and it was going directly in the face of calling a recession here. So it tends to not, there are reasons and scenarios where it can be wrong.
(18:39)
Another one that's thrown around quite a bit, the leading economic indicators, right? That's been in negative territory for over a year and a half, but not a lot of people focus on the fact that one that gets revised after each cycle to make it a little bit more accurate and a better forecaster. So you're just basically fine tuning it to prior cycles that have already played out. But more importantly, if you're doing that and this cycle is different, which we've kind of laid out today, then it's not necessarily going to be as realistic and reliable. And part of the reason is because it's such a heavy manufacturing index. Well, manufacturing has been in contraction for over a year at this point, and part of that's because of those bloated inventories that are getting worked down now you're starting to see that pick up all the while the services side of the economy held up.
(19:27)
So I think broadly there's maybe a little bit of over appreciation for how some of these historical indicators have worked in the past. They've been pretty good, but they're not perfect. There are some caveats being keep in mind, but the other one is I think there's just a simple reflex to say if we're tightening policy, then it's going to be escalator up in terms of policy rates over Titan and then elevator shaft down and it doesn't always have to work that way. And ultimately I think it's overestimation of how rate sensitive and how powerful monetary policy is. Now the last one I would say is the unique dynamics of this cycle. It's created a lot of economic syncopation, so a lot of ebbs and flows in one area of the economy that's offset by ebbs and flows in another. So again, kind of the manufacturing and services manufacturing is under pressure at the same time as services has been raging and that helps to keep the overall economy intact.
(20:26)
And so we still are dealing with I think a little bit of the residual echo effects from that massive bull that basically rips through the entire economy because of the pandemic. And I think it's missing some of those syncopations and those echo effects that's led people to believe that weakness in one area of the economy must mean weakness throughout the entire economy. And that just simply hasn't been the case here. So a lot of different drivers, but at the end of the day, I think it goes back to maybe under appreciating the unique dynamics of this cycle and over appreciating how powerful monetary policy can be.
Lynne Funk (21:00):
Okay, so sticking with this expectations, experts been calling for a recession for every year. We don't seem close to one. Will the delay or lack of a recession slow the rate of disinflation?
Garrett Melson (21:14):
Yeah, I mean that's kind of the common wisdom and that's what econ 1 0 1 would say. But if that was the case then we shouldn't have been able to have the last six months that we've had, right? Where growth has been 5% in one quarter, over 3% in the next, and yet we've had a massive disinflationary impulse over that period. So I think that speaks to the fact, and Powell has mentioned this since the November meeting. This was I think a really important tone shift. I think there was a lot of fear that if growth remained resilient, the Fed would not be comfortable easing rates and be convinced that inflation is moving back to target. And Powell basically put that fear aside back in the November presser. And big reason why is because there's a strong case be made. And he mentioned this yesterday as well, that we're in a period where potential growth, so basically the productive capacity of the economy is temporarily higher as that supply side of the economy continues to recover.
(22:15)
And what does that mean? It means that we can run much stronger levels of real growth and still have that be compatible with continued disinflation. And so I think ultimately that's not really a risk that strong growth is going to slow down the pace of disinflation. We've seen a massive amount of disinflation. There's still quite a bit of a pipeline in the pipeline and shelter as I mentioned, kind of mechanically because we know the inherent lags in terms of how that's measured. But when you also take a look at some other segments of the economy, I still think there's fears about some of the shipping disruptions from what's going on in Red Sea, but ultimately I still think there's a little bit more juice to squeeze and so does the fed from normalization in the supply side of the economy. And so ultimately those together can still continue to see strong growth and continue disinflation.
(23:04)
And the other one is we've seen just this morning, take a look at that continued run in productivity growth. That is a huge disinflationary impulse. So strong productivity can be a big buffer to stronger growth not driving into inflation here. And I think a lot of that boils down to a maturing and a lengthening tenure of the labor market. The more you have maturing in the labor market and great participation in the labor market, the more that eventually translates into efficiencies and productivity gains. I think that's exactly what we're seeing play out right now. So I don't think the lack of a recession slows the fed's progress. I think you can continue to see strong real growth at the same time you're seeing disinflation. And again, that goes right back to the Goldilocks soft landing scenario.
Lynne Funk (23:53):
Okay. Do you think the market's expectations are moving maybe more aligning closer to the Fed's at this point?
Garrett Melson (24:00):
Yeah, we touched on that briefly, but I don't think there's as much as a disconnect as what it looks like on the surface. And again, that's because when you think about market and rate pricing, especially in say the SR curve, you have to think about that in terms of distributional probability weighted distribution of about outcomes. So a mouthful basically to say there's going to be probabilities of all these different outcomes and the probabilities of those and the ensuing rate cuts is what gives you the aggregate pricing in the market. So the way I like to think about it is you go back to say fourth quarter of last year where tenure was pushing up over 10% and you basically have the SR curve pricing policy rates to remain above 4% for the next 10 years. Well, what you did is you actually chopped off that right tail as inflation continued to fall down, the Fed pivot kind of gave confidence that they would ease before inflation rates 2%, you're chopping off those probabilities of the right tail.
(24:58)
So basically you're taking all those probabilities of increased hikes and bringing that down to zero and that's going to shift your distribution to the left or down increasing the number of cuts. I think that's still what's happening here. When you look at where the mode of the distribution is, so where the bulk of those probabilities are, it's still right around three or four cuts. There's still some kind of residual hedging pricing and recession risk pricing, and I think that's dragging down the overall market pricing to something like six cuts. But when you really think of what's the base case for the market, I think it's closer to about three or 4% when you look at the probabilities here that are being priced into the futures and the options markets on rates. So I don't think that disconnect is quite as great.
Lynne Funk (25:46):
So I actually have a question from the audience that I think maybe fits in right now that I'd like to ask before I continue with mine. And the question is, can you speak to the real estate market and the huge number of companies and employees in these related industries that are affected by higher interest rates once rates start to drop, how long will it take for commercial real estate and residential markets to take to have some recovery?
Garrett Melson (26:11):
Yeah, that's a great question. Obviously that kind of ties into some of the fears in the marketplace over the last couple days. I think a lot of the fears around CRE are a little bit overdone. I don't see that as much of a systemic risk when you see a lot of the numbers, $2.7, $2.8 trillion sitting on small bank balance sheets, that's a scary number. But when you really look at what the problem sectors are in industries, obviously we know it's office. And when you look at small bank exposures, problem areas, office space, it's only about 3% of their loan books. So it's fairly small and a lot of those are actually concentrated in some of the secondary and tertiary markets. The real issues in the office space is in your primary market, central business districts, and a lot of that debt is actually securitized. So that's kind of spread out across investor bases and that means that a lot of those systemic risks just aren't there for the banking sector.
(27:08)
So that's something I think is important to keep in mind is we kind of have these renewed fears of bank stress and commercial real estate driving some slowing and potential risks for the broader economy. The other side of the equation though, on employment and housing, I think that's really interesting. I mentioned that as a countercyclical force, but if our base case is right, you're going to have nominal growth slowing over the course of this year, right? Real growth is going to hold up, but inflation continues to move back to target. And that's really at the end of the day, what tends to drive longer term nominal yields. So if that's kind of your base case for mortgage rates, the other side of it is volatility, higher volatility tends to drive wider mortgage spreads that has been compressing. And I think as we get past this kind of inflationary battle and the outcomes become a little bit more narrow, that distribution of outcomes, then volatility starts to compress.
(28:02)
I think that's going to be really powerful to drive a compression in mortgage spreads. You can start seeing mortgages with a five handle that's going to be driving a lot of demand coming off the sidelines when you think about the millennial generation bulge coming into that peak household formation age. So yeah, it's been painful over the last year and a half in those sectors, but I think you're actually on the verge of seeing a pretty significant recovery in specifically residential housing, maybe a little bit less and multifamily, you already have a lot of construction there in that space that's going to be coming to market. And so you've seen a slowdown in that space. But the residential side, I think you'll start to see pick up pretty dramatically. And the other thing keep in mind is there's been a lot of construction spending on manufacturing capacity. So this idea of reshoring, but also taking advantage of some of the legislative action passed through the chips in the IRA that's been drawing because of the incentives that's been drawing manufacturing, construction spending and it's been surging. And that's a theme that could continue, especially if the growth outlook continues to hold up. So I think we are certainly on the verge of potentially seeing a meaningful recovery in those segments of the economy as we move through the year.
Lynne Funk (29:11):
Okay, so I should wait a little while longer before I purchase an apartment in New York.
Garrett Melson (29:17):
I don't know. You might want to get started and get a jump off before the demand comes brewing back.
Lynne Funk (29:22):
Alright, fair, fair. So what are the biggest, so we talked, can you talk about any of the biggest risks to the economy as you see it?
Garrett Melson (29:33):
Yeah, that's a good one. I think there's still probably some residual fear. As much as disinflation seems to be entrenched, I think there is some fear that the last mile will be still difficult and we might plateau above target. I think that's part of what goes into the Fed's risk management decisions. The bigger risk to me though is probably labor market deterioration. And I don't think either of these are necessarily very high probability, but we certainly have seen the labor market normalize and that's come back into balance. And that's a big reason why the Fed has abandoned its tightening bias. The dual mandates basically back into equilibrium. But when you have the labor market that's gotten back into more balance, that means you're buffer to some of these shocks is a little bit less. And so there is an increased risk of deterioration in the labor market.
(30:23)
And when it comes to the labor market, you have to keep in mind there is a non-linear risk there. When you start to see some layoffs, that means consumption might start to slow and then that triggers further layoffs and you can see that vicious cycle here. So that would be the thing I'm keeping a closer eye on. I don't think that's a huge risk right now from what we're seeing, people that are being laid off. Again, it's much more for restructuring reasons and there's still some demand out there for them to get a job fairly quickly. But that would be the key from our perspective. If you see material weakening in the labor market, that's the biggest risk to the economy and that's probably going to elicit much more rapid and greater response from the Fed. And that's something Powell alluded to yesterday as well.
Lynne Funk (31:08):
Okay. This is a question from the audience. When you're looking at labor, how do we explain the disparity between ADP and BLS monthly reports? It has appeared that BLS headline numbers have been consistently revised.
Garrett Melson (31:24):
So the answer is the ADP has never been a reliable indicator for BLS, never has, doesn't seem like it will be. They made a very significant methodology change, I believe it was last year, maybe the end of 2022 to try to get it aligned a little bit better with the non-farm payrolls. But it still hasn't been great. It is useful for some data points. I'd say probably the wage data is the best part of it, but at the end of the day when you just look at the hit rate, it has very little informational content for the BLS. And yes, we've heard quite a bit about how all the revisions for non-farm payrolls have been negative, but it still doesn't really change the trend. The trend has been we still have strong jobs growth, it has been decelerating and we've seen cyclical employment slowing, but it's still holding up. And that's really the theme. So you can talk about revisions and downward revisions, but bottom line is ADP has never been a reliable indicator for non-farm. So yeah, we always see it. It comes out in advance on that Wednesday before the Friday non-farm payrolls release. But I would never trade on that other than a knee jerk reaction and maybe some other investors trading on it. But the bigger picture is revisions on non-farm payrolls don't really change the theme, which is a moderating labor market that is still very strong.
Lynne Funk (32:45):
Okay, so what does all of this mean for the bond market?
Garrett Melson (32:50):
Yeah, that's where the rubber meets the road, right? We've spent a lot of time looking at some indicators for where fair value should be on tens. Obviously markets are going to trade based on fundamentals, but also technicals and a lot of the short-term moves are going to be more technical in nature. Just for example, you look at the sell-off in the rates market last year and our fair value model has been pretty accurate over time and it was right around 4.30%, 4.35% as the 10-year was ticking up to 5%. And to that to us spoke of a massive technical and kind of narrative driven overshoot and we expected a rally and we got it maybe a little bit more vicious and extreme than we expected, but that certainly is what played out. As we look at over the next year, I think we're probably in somewhat of a wide range for say the 10-year, right?
(33:43)
Anywhere from 3.25 to 4.25, and that feels like a little bit of a cop out. But I think the bigger theme is that over the course of the year, we would expect to be drifting towards the lower end of that range. And it goes back to this tug of war between real growth and nominal growth. And I think that's been a struggle for a lot of investors. They tend to move in line, but in this environment where the supply side is picking up and disinflation is so strong, they've kind of been moving in opposite directions. So real growth has been accelerating at the same time. Nominal growth has slowed because of inflation falling so dramatically. But I mentioned earlier, basically at the end of the day what drives nominal yields is nominal growth inflation and real growth. And so I think that's going to speak to an environment where tens probably settle into 3.25 to 3.50 by year end.
(34:30)
You probably continue to have a fairly flat curve just because it's going to take some time for the Fed to fully recalibrate policy back to something more neutral and consistent with 2% inflation and maybe something around high one slope, 2% growth. But ultimately I think that's where we're likely headed. And if you take a little step further outside of just treasuries, I still think it's a very compelling backdrop for credit in this environment. Again, nom growth isn't falling off a cliff, it's holding up after decelerating from very robust levels, and that's kind of your proxy for revenue growth for corporates. And so as revenue growth holds up, that means that interest coverage continues to be strong. Leverage isn't extreme, especially on a net basis. And credit and spreads might be tight, but you're all in carry. When you add in what you're getting from on top of treasuries, it's pretty attractive. And so I think that's an area both high-yield and investment grade that I think looks attractive to us. So it looks like a year of probably duration doing well as yields continue to move lower, but carry doing very well in some of the plus sectors and credit.
Lynne Funk (35:45):
So I have a couple more questions for you, but actually I'm going to start with this one. What do you think about, do you think anything about the elections, will they get in the way of Fed policies? Do you have any thoughts on the 2024 elections?
Garrett Melson (36:01):
Yeah, I mean the base case right now is however it shakes out, there's an expectation of gridlock. So no clean sweep by either party. And you look historically that's a good thing for markets, right? Markets like gridlock, it reduces the odds of any serious and substantially different legislative packages getting passed. And so that's kind of the base case right now. But the bigger picture is it's always a talking point. It's always a source of potential short-term volatility in markets. But at the end of the day, it doesn't tend to have much of a lasting effect on the market as long as corporates and the market know what the new rules are based off the platform for either candidate, they can adapt and they can continue to put up strong results and the market can continue on the trend that it was on before. So I think it's kind of a sideshow in any given year. It's more of a sideshow than anything. Yes, it has the potential for short-term volatility, but from a bigger picture perspective, what's going to be driving the markets I think over the course of the year is it goes back to the same themes we've already talked about, right? Growth is holding up inflation, settling back to target labor markets holding up and the Fed moving to an easing bias. And I think that's going to mean risk assets are bias higher and rates probably yields are probably headed lower.
Lynne Funk (37:18):
Okay. So what questions are you getting from your clients? What are they worried about?
Garrett Melson (37:24):
Yeah, I think not a whole lot different from what we've talked about today. I still think there are some residual fears of all hard landings start off looking like a soft landing, right? That's kind of a theme we've heard quite a bit recently. So I still think there's a little bit of fear that going back to those lags on monetary policy, maybe we haven't quite felt all the effects just yet and that's going to start weighing and the Fed doesn't move early enough. We're certainly not in that camp, but I think that's still fear that's out there. Another one again is do we start to kind of plateau and settle into a level of inflation that's still a little bit too sticky and a little bit too high above the fed's target? Again, not something that we're seeing evidence of. If anything, I'd say the pace of Disinflation even through this year could be faster than markets and the Fed expects, and we could be looking at approaching very closely 2% by the end of the second quarter.
(38:18)
Everything has to go perfectly. But we've been getting a lot of that. And basically if we string together more of that over the next couple months, what we've gotten over the last six, seven months, that's definitely within the realm of possibility here. So I think at the end of the day it boils back down to growth and it boils back down to inflation that are still a lot of the key concerns we hear from investors. And we already touched on it on the real estate side, but again, that unfortunate theme of commercial real estate rearing its head in banking sector, which as I mentioned I think is very much overdone from a systemic risk perspective. So those I'd say are probably the biggest risks that we continue to hear from clients these days.
Lynne Funk (38:59):
Okay. So is there anything that I didn't ask you about that perhaps you wanted to touch on? AI machine learning?
Garrett Melson (39:09):
Yeah, honestly, I loved what we've run through today. I think that really covers the bulk of it. And if I haven't said it enough, I think the key for us, obviously we're on kind of a Fed recap and talking about the future of Fed policy, but from our perspective, I don't think it matters nearly as much as we want to think it does. And so the exact timing of when the first cut comes and the exact number of how many cuts we get this year and how many bleed over into next year, as long as growth is not falling off a cliff. And as long as more hikes and stickier inflation are somewhat off the table, those two tails, we're basically in the middle of that distribution of outcomes from a policy perspective. And that is going to be supportive of risk appetite. And I think that's the bigger key here. So we like to focus on policy and balance sheet from the Fed and all of that, but at the end of the day, what really drives markets is going to be risk appetite. And if we're in the middle of that distribution, I think that's going to be supportive for risk appetite to continue to recover over the course of this year. And that's I think the big theme and takeaway from our perspective.
Lynne Funk (40:17):
Okay. Excellent. Well, I think that's all we have for today. Thank you so much for joining us. It was a great discussion. Obviously it's going to continue. It's going to be an interesting year. Really appreciate your insights and thank you to the audience for joining in, and we'll see you next time. Thank you so much to Garrett Melson, and take care everybody.
Garrett Melson (40:43):
Thank you very much. Take care.
