From the lame duck session to a new administration, how to think about rates, macro and the Fed ahead

Welcome to the MEFG Global Markets Podcast. I'm Jonathan Wong, an analyst on the MEFG macro strategy team, and today I'm joined by our team lead, George Concaldis, head of U.S. macro strategy. It's Wednesday, November 27th, 2024.

Welcome back to the podcast, George. Hi, Jonathan. Thanks for hosting the podcast.

George, as you have been saying for the last few weeks, it feels like there are more questions now after the start of FedEasing and post-election versus answers. That said, we just released our latest report, the U.S. Macro to Markets Monthly, titled Markets Feel Like Post-Election, Now What?

Let's explore the piece and some of the questions we are trying to answer. First off, let's get the Fed and our updated rates forecast out of the way. What are we thinking now in terms of our cut at the December meeting and what Fed policy will be like in 2025, and how does this relate out the curve?

That's a great question. And I think we're at an interesting crossroads for the Fed and Fed's reaction function to the near-term data versus what may lie ahead for the economy now under a Trump administration and a full Republican sweep in Congress. What that might look like, what sort of policies are going to be put in place, both that are pro-growth and some that are going to potentially change government spending as well as retool how things are done down in T.C., could lead to some unintended consequences or at least some factors offsetting each other.

And I think that's going to potentially complicate how both the bond market, but also how the Fed is going to be interpreting what lies ahead for the U.S. economy at this juncture. Taking it one step at a time and looking at the near-term, at the end of the year, we're getting the last Fed meeting, December 18th in the middle of the month, it's an SEP forecast meeting. So they're going to have the new estimates for their views on both interest rates, growth and inflation and employment.

We care mostly about their views around at least what their rates views look like and how that compares to market pricing. At this stage, we still believe that they're going to cut in December, they cut 50, they cut 25. And now we think that they complete the year with another 25 for a complete 100 basis points of cut, which would match their latest forecast or estimates that were from the September meeting.

We think that makes a lot of sense because, A, it's cleaner, it's already in their path that they projected. So delivering another 25 basis points when it's been on and off priced in shouldn't be too challenging. The recent Fed minutes also alluded to the majority of the respondents within the Fed do think it's appropriate for another cut to wrap up the year in December.

We do, I think, also have to be mindful of the fact that it's the end of the year and not cutting at this time without any really reason not to cut, I think, would be more disruptive and really impact market functioning. And why would the Fed want to do that at the end of the year where markets are more sensitive around liquidity? There was mentioned of potentially adjusting the RRP interest rate by five basis points, doing that but not cutting rates, what's the point?

You get more mileage if you did both, especially at this inflection point for both the economy and markets into the next year. I think it would make no sense for them not to cut. And as you and I both know, there's a lot of banks still sitting with losses in their HQLA, MBS, and Treasury books.

Why add to more losses at the end of the year? And that's a short list of reasons why they can do it. The real reason is only not to skip and we don't think this is the case.

If the last real data point is NFP and then we have also CPI before the Fed, but NFP will take place right up to the blackout window on December 6th. At this juncture, unless NFP is really something like $250,000 or more and the back months are revised significantly higher, even then, we have a hard time seeing such an outcome taking place. The trends for jobs data has been decelerating and I don't think that the election itself has altered that trajectory of the jobs market this quickly.

We're in the lame duck session. Companies are still trying to figure out what policy might look like in the future. So we highly doubt that hiring has restarted, not to mention that the survey week for NFP was during the election, which people were on pins and needles waiting to see the outcome.

I highly doubt that corporate America or small businesses were hiring enough during the first 12 days of November. So there's actually probably downside risks to NFP, to be honest, which would really cement the actual cut in December. So yeah, we're thinking they cut, that brings it to a total of 100 basis points.

The top of the band at around 4.5. We think then for 2025, that's going to get a little bit more challenging. There's a lot more different paths ahead.

We do believe that it's more appropriate if they're going to pause or start to skip meetings that they wait to next year and to get some clarity around fiscal policy. But for now, we penciled in that they skip in January and then they start cutting every other meeting beginning in March, which would take them down to roughly a 3.5, 3.75 range. But again, this is really subject to change, as most of our listeners and readers know, that there's been a red wave and that there's been some concerns about both the inflation risks ahead as well as additional spending by the government, which could translate into higher rates as well as more economic activity, which would then slow down Fed cuts.

But any sort of delay in the implementation of policy or if there is some sort of external shock or something happens that actually the economy decelerates, the Fed has plenty of room to cut even further. So our bias is that it's anything that derails the more optimistic outlook that's largely priced into financial markets and the economy weakens, the Fed has the ability to cut more than our pretty conservative rates forecast for the Fed. And then what that means out the curve, it does suggest that the two-year is probably the one area of the curve that will continue to decline.

We do have the two-year going back under 4% in 2025. And where I think we have a different view than we typically have had, historically we've been known as more bond bulls or dovish on policy. But I do think that the 10-year probably trades in a pretty decent range.

Maybe it's 4% to 5% in the near term, 4.25%, 4.50%. But then once we clearly break above 4.5%, which I think is going to be challenging at first and would really require a really strong economy that's responding favorably to a Trump 2.0. But there is scope that we could get above 4.5%, and I think we'll take it from there.

But at this point, we have embedded both the more optimistic outlook that a kind of one party rule with a more kind of business friendly, less regulatory, more spending tax cuts should continue to see the economy continue to grow. But there's obviously risks to that outlook on the implementation and the sequencing of those policies. Moving beyond the Fed and monetary policy, President-elect Trump has rounded out his cabinet picks, but the big one that the markets were waiting for was the Treasury Secretary, with Trump eventually picking Scott DeSantis.

What do we know about his economic policy views, thoughts on tariffs, and what are the challenges for the Treasury ahead? We were definitely waiting for that. That was one of the last major cabinet nominations that President-elect Trump announced last week or the Friday before the weekend of this recording.

And we've been kind of for the better part of this short holiday week trying to understand what are the views of Scott DeSantis. Luckily, we've been fortunate enough that Scott DeSantis had a pretty clear plan and pretty straightforward outlined as his 3-3-3 plan, which is this idea of making sure the economy continues to grow or actually achieves a consistent 3 percent growth. Because although we've had times where the economy has grown at 3 percent in real terms, it hasn't been consistent.

It's been on and off. And the plan, at least what he's kind of envisioning, would require consistent 3 percent growth to really help with our debt financing, as well as keep the economy on track. The other three would be reducing the deficit to 3 percent of GDP on a per annum basis.

Currently, it's anywhere between 6 and 7 percent. These are sort of levels that typically only happen during a recession or during war-like periods. 7 percent deficit to GDP is really tacking on the debt very quickly and running the economy very hot. And in many ways, the government spending is what was keeping the economy growing for the last few years.

Restructuring that back to a more private sector-led growth and less government spending will help get our house in order on the fiscal side. At least that's the game plan, going from 7 percent down to 3 percent. And then the last three is this 3 million barrels per day of additional oil production.

The U.S. is roughly at around a high rate of 13 million barrels per day. Another 3 million could prove both disinflationary as well as add to local growth to the economy, which would kind of feed back into the GDP side of things. And probably would also require some retooling of the Inflation Reduction Act or priorities thereof around green energy policies, the deregulation of energy, not just financial.

So, yeah, I think there's a lot of hope around that. Yes, Scott Bissett also has viewed tariffs as a tool, so it's in line with the president's thinking as well as the U.S. trade representative position around tariffs. Although the Treasury Secretary does not create the actual tariff, it will be part of that discussion most likely.

And it's a way to raise revenue, which also helps out when trying to figure out debt management as well as revenue for the country. Scott's view is that it's a bargaining chip. I think that that's a general view for the Trump administration at large.

The tariffs are something that they don't want to put in place, that their trade policy is about free trade. But if the U.S. is not getting a fair deal, that their view is that tariffs can be used as a negotiation tactic. We'll see how it goes.

I mean, I know there's a lot of tension around the idea of tariffs and what it might mean for raising prices, considering that the U.S. does import a lot of goods. There might be smarter, more effective ways of implementing the tariffs, like for one, which is this is how our idea, at least as a brainstorming session, having a staggered or forward starting schedule to tariffs where you say, hey, there's certain stipulations that have to be met. If you don't meet these criteria, then the tariffs kick in at a later date, you know, forward starting in the future.

You can avoid a tariff if you either invest in the U.S. or do some sort of pro quo and buy some of our goods. So I think there's, you know, we'll see how the tariff part plays out. But that's really not the domain of the Treasury per se.

One thing that, you know, I think, you know, Scott Besant also has been very vocal about is how we're funding our government in terms of the debt stack. You know, the U.S. has a lot of short term bonds that it has to consistently roll over. Now, a part of that is market structure.

There's a preference to short term bills for both the lateral that is used by the financial system and the repo markets to help disintermediate and provide liquidity into the broader banking system. But, you know, and also the money market funds have become really large in the U.S. But, you know, in general, there's a lot of debt that rolls over at the most expensive part of the curve, which is a very flat to inverted curve for the last few years.

And we've been paying the highest cost of funding to keep our debt rolling over. You know what they do with that, plus any additional deficit. We're looking at maybe 12 trillion dollars that has to get issued on next year in 2025.

And the composition of how that's financed, I think it's going to be probably a big focus of the Treasury secretary on a go forward basis. We've covered a lot of topics in our November monthly. So we encourage our listeners to go report.

But one last question was on small and medium sized enterprises and consumers. Why the focus and why has it been such a key macro factor for our overall house view? Yeah, so I'll wrap things up with with the idea that we are dealing with these new factors, like how will the Fed react to fiscal policy, fiscal policy itself, as well as other government policies can alter the trajectory of the economy in the country.

And so those those are really occupying a lot of the attention and focus of market participants and strategists like ourselves and economists. But I think we can't lose sight of the fact that there is underlying macro forces that have been in motion already and that this business cycle has been different than every other cycle. And even though we have a new leadership in the US, it takes time for those policies to get implemented.

And whatever sort of path the country was already in is not going to be completely altered in the very short term. And so we do think that some of the topics that we've been focusing on for the better part of 18 months are not going to just go away and not be relevant. And one of those big topics was the or two of those big topics was that the regional banking system crisis and the fact that the higher rate environment has really curtailed credit formation in the traditional banking world to the broader economy.

And that's been largely felt by the lower to middle income households, but also small businesses which employ a lot of folks. And this kind of connection of taking it back to what happened in 2023 and the banks really not being as big a part of the economy as they used to be. And that resulting in less private sector job growth and also higher cost of funding for these small businesses and for households that have auto loans, credit card loans and student loans and a lot of other consumer based loans, that the interest rate channel has mattered.

It just has mattered differently in this business cycle than before. And that perhaps the Fed is overstaying higher for longer. It runs the risk of really hurting these sectors of the economy while we wait for the changes from the new administration.

So, yeah, it's really just a reminder for those, you know, definitely go check out our monthly and read the special topic and try to get an understanding that the U.S. economy has really has changed in the last few years, basically the last decade or so where we have what many of us kind of coined the idea of the K-shaped economy where there's an upper K, which is the upper income, which is really benefiting from higher financial assets and, you know, and then resulting in less savings and consumption stays strong. And then there's the lower K of the economy, which has really been falling behind in many ways. One could argue that the working class is kind of what voted in the Trump administration 2.0.

So it's going to be interesting to see how the kind of the intersection of how to keep the economy working for everyone without really derailing financial markets as well as providing opportunities for others. It's going to be an interesting next couple of years and we'll see how it goes. But, you know, from our point of view, the rate level could be at least a bridge loan for these cohorts, which have been suffering from higher rates.

If the Fed were to continue to cut rates steep in the curve, encourage the banks to lend, that could really help out some of these small businesses and households which have been struggling. Thanks for that, George. Thanks, Jonathan.

Thanks for moderating. We would like to remind our listeners, for those that would like to receive Georgia's strategy reports directly, please email your MEFG sales coverage or get in contact with George directly on email or via Bloomberg. Thank you for listening to the MEFG Global Markets podcast.

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