Economic Commentary

Executive summary

The Federal Reserve (Fed) policymakers held the federal funds rate steady, now unchanged for a full year. The committee also maintained the slower pace of their balance sheet runoff. 

Chair Jerome Powell laid the groundwork for a September rate cut, in our opinion, flatly stating "it could be September if the data supports it." Of course, he noted many caveats regarding if data worsened, leaving the Fed some breathing room if data were to zag between now and September.

Based on the positive reaction in U.S. stock and bond markets, investors seem convinced that the Fed will change course in September.

We believe that the Fed has the consensus it needs – both internally on the committee and by markets – to make the first rate cut of this cycle in September. 

What happened

At its July rate-setting meeting, the Federal Open Market Committee (FOMC) unanimously agreed to leave its target range for the federal funds rate at 5.25% to 5.50%, where it has been since the July 2023 meeting. The pace of its balance sheet runoff (i.e., quantitative tightening, or QT) is also unchanged at $60 billion per month with the monthly redemption cap of $25 billion for Treasury securities and agency mortgage‑backed securities (MBS) set at $35 billion.

The meeting statement included “the Committee is attentive to the risks to both sides of its dual mandate,” which Chair Powell reiterated during the post-meeting press conference.

Chair Powell deftly navigated questions about “when might rate cuts come?” saying that the committee had made no decisions regarding future meetings. Furthermore, Powell clearly stated that a decision wouldn’t hinge on any one data point but rather the totality of the situation.

Powell noted real progress on inflation, although not enough to lower rates quite yet. He also acknowledged that interest rates remained restrictive as evidenced by the recent increases in the unemployment rate. He categorized it as a “normalizing” labor market, along with other factors, such as seasonality and the uniqueness of the pandemic and the subsequent recovery. 

Our take

Our take is the Fed is prepared to move in September barring a major turn in the economic data. As the kids say, “say it without saying it.” In our view, Chair Powell outlined what the committee would like to see to cut rates in September.

Moreover, Chair Powell appeared increasingly dovish as the press conference continued. For instance, he acknowledged that interest rates remain restrictive currently, meaning doing nothing stifles economic growth.

Unlike the June meeting and the committee’s June economic projections that seemed to spur more questions than answers, today’s meeting added to our conviction for a September rate cut. From a pacing perspective, we anticipate quarterly rate cuts through 2025 (for now). Naturally, the pacing will be continually reassessed meeting by meeting.

Bond market reaction

Over the past three months, softening inflation and economic activity paired with less-hawkish commentary from Fed policymakers drove U.S Treasury yields meaningfully lower across the curve. The 2-year and 10-year U.S. Treasury yields are roughly 0.7% and 0.6% lower since April 30^th, respectively, and at their lowest levels since the first quarter. The Fed’s decision to hold the federal funds rate steady today was widely expected, resulting in a muted immediate response from U.S. fixed income markets.

Fed Chair Powell’s press conference largely aligned with market expectations headed into the FOMC meeting and with the more balanced view laid out in the statement. However, towards the end of the press conference, Powell’s affirmation that a September cut was squarely on the table fueled a bit of a stronger bond rally (i.e., lower yields). Fed funds futures trading reflects 1) stronger conviction that a September rate cut is coming, barring a disruption to the positive inflation trends; and 2) the Fed is expected to lower the federal funds rate by two or three times by year-end (in 0.25% increments). The 2-year and 10-year U.S. Treasury yields settled around 4.27% and 4.05%, respectively. Put together, the 2-year/10-year yield curve remains inverted by -0.22%, extending the longest inversion on record.

The approaching start to a new Fed rate cut cycle reinforces our view that yields in the front end of the curve have peaked and will continue to fall in the months ahead. For investors seeking high quality, passive income with lower interest rate exposure, we recommend a sense of urgency in deploying cash before the Fed’s rate cut cycle is well underway. However, reinvestment risk remains a key portfolio consideration. In other words, the risk is rising that short-dated bonds purchased today are likely to mature into a lower interest rate environment than where yields stand currently.

The 10-year U.S. Treasury yield is an important driver of consumer and business borrowing costs. The recent decline in yields has eased some pressure on interest-rate sensitive spending. However, from an investment standpoint, the decline has diminished the value in aggressively extending portfolio duration. We expect yields to broadly trend somewhat lower from their current levels (especially in the front end of the yield curve) as inflation cools, U.S. growth moderates, and the Fed ultimately eases policy. However, federal deficit concerns could cause periodic challenges to our view, and would prevent yields from falling as far as they would absent growing fiscal imbalances in the U.S.

Bottom line

The Fed is poised to begin cutting interest rates at the September meeting barring a major turn in the economic data between now and then. We maintain our view that the U.S. economy is cooling but not weak. It also appears likely that continued progress on inflation should translate into two rate cuts before the end of the year.