Top of the Morning: CIO Strategy Snapshot - All eyes on the Fed
The desk anticipates a bullish shift in market dynamics following the forthcoming FOMC meeting, given the current robust performance in equities and the potential for rate cuts. Per the full note from UBS, market indicators show that while economic growth and inflation pressures had initially suggested a weakening outlook, recent data challenges this narrative as markets have continued to rally, with the S&P reaching all-time highs. This positive trajectory aligns with expectations that the Fed will consider rate cuts as early as this week, potentially catalyzing further market advances.
What the desk is arguing
The desk believes that the upcoming FOMC meeting will act as a pivotal catalyst for equity and bond markets, paving the way for a more favorable investment climate. This perspective is reinforced by UBS's view that economic conditions are not deteriorating as previously anticipated, which has resulted in a disconnect between economic forecasts and market performance.
Key indicators suggest that markets are not only growing but are doing so against a backdrop of declining bond yields, which typically signals increased risk appetite among investors. Such positive market sentiment could embolden the Fed to signal a more dovish stance.
Where it sits in our coverage
Current consensus on the EUR/USD positions it at 1.075, with the following notable forecasts: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)
This positioning aligns with our desk’s bullish stance relative to the broader consensus, as it sits near the upper bound of the forecast range, indicating an optimistic outlook amidst evolving economic indicators.
How other firms see it
Aligning firms believe that the dovish pivot from the Fed will continue to support markets, while contrary views focus on potential economic weaknesses and inflationary pressures. Notably, bofa remains skeptical about sustained growth, contrasting with a more positive outlook from jpmorgan.
Key related indicators include the trajectory of the USD index and potential movements in bond yields, which will serve as watch points for market participants basing their strategies on central bank signals and inflation data.
01Expect market support from potential Fed rate cuts.
02Recent economic data contradicts prior bearish forecasts.
03Equities hit all-time highs, reflecting investor optimism.
04Watch for the Fed's dovish signals post-FOMC meeting.
Market implications
Traders should monitor the S&P 500 levels for signs of continued strength, particularly if the FOMC meeting reveals any unexpected dovish guidance from the Fed. A decisive break above recent highs could trigger further bullish sentiment across markets.
Risks to this view
A shift back to tightening monetary policy by the Fed, driven by unexpected inflation data, could undermine current market optimism and lead to a reversal in risk appetite. Watch for any signals of strong labor market reports that may prompt a more aggressive Fed stance.
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Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. Financial markets continued their relentless climb higher last week with concerns about bad seasonal performance in September proving no match for economic and earnings data.
All eyes will be on the Fed this week as rate cuts are expected to resume. So joining us today to discuss this all after a late summer break, glad to welcome back Head of Asset Allocation for the Americas with the UBS Chief Investment Office, Jason Draho. Jason, great to be back on the mic with you.
Thank you for dropping by and for spending some time with their listeners and their clients on this Monday morning. Morning, Dan. Happy Monday.
It's been a few weeks. Still feels like summer here in the Northeast. That's nice.
It doesn't feel like things have changed too much. Definitely. Hopefully, we can squeeze out a few more weeks of summer though.
Jason, I know it's been a few weeks since we last spoke. Let's begin with market performance and what's behind this grind higher in markets. What do you see as the catalysts?
Well, it does seem like for equity markets but also now even bond markets that this kind of higher is continued with S&P at all-time highs but also bond yields going lower on both sides of both equities and bonds. It's been positive performance of late. Thinking about what are the catalysts behind this start from the overall macro, the view that we talked about a few weeks ago is that the consensus was economic growth and economic data would get worse before it got better.
You'd see slowdown of growth. You'd see weakness of the labor market. Inflation would go higher, sort of a stagflationary impulse to the data.
This would play out largely though through the end of this year, like through the second half of 2025, giving way to better macro data in 2026 where growth starts to reaccelerate, inflation starts to roll over, and you have a Fed that's cutting rates. So from something stagflationary to something that looks more like kind of Goldilocks type of data. So investors have been willing to look through some of the weaker and worse economic data in anticipation of the better times ahead.
The way I characterize it is investors kind of expect both growth data to in place data and the Fed to kind of thread the needle towards a soft landing by next year where you get these much more kind of benign conditions. And so even if you look at some of the labor market data, that has definitely sort of been disappointing. We've had a weak number of prints for the past couple of months, plus now data that would suggest acquired job growth is much less than expected.
The investor consensus thus far has been, while the labor market is softening, the recession risk still remains relatively low. So that's the macro condition. That's why you're seeing kind of this ideal sweet spot of equity markets looking through any kind of growth weakness to better times ahead.
Earnings have been solid. Bond investors do expect now rate cuts because growth is slowing. Inflation hasn't been as bad as feared because of tariffs.
So again, you get some almost insurance Fed rate cuts. That's the macro narrative that's been driving things continually higher throughout the summer. It does mean there's not a lot of margin for error if the Fed disappoints, it doesn't cut as much of inflation, and the next couple of months actually starts to really show impact of tariffs.
Or maybe most likely if we start to see the labor market further crack and get a negative job sprint to suggest that perhaps the Fed is not just doing insurance cuts, but now has to be more aggressive in cutting to stabilize the economy. I think then you'd get situations where the markets would pull back. But at the moment, everything is kind of lining up from the market's perspective that things will be good.
We're looking to head next year. This is reflective in volatility. The VIX, Volatility Index for equities is around its year-to-date lows.
And then if you go to interest rate volatility, it's the lows that's been since prior to the start of Fed rate hikes beginning, which happened in March of 2022. So it's been about three and a half years or almost four years since rate volatility has been this low. That also encourages investors of different types to take on more risk.
Investor positioning at the start of the summer was, I'd say, below average. It's continued to move in a direction of being a little more risk-on. That's been a tailwind.
But it's also not necessarily stretched. So this is really what's been driving it is supportive macro, expectations for a supportive Fed. Earnings have been solid, better than the economic data.
And then, of course, the AI theme, which continues to power forward. And last week, the news and the reporting from Oracle for their earnings further was another data point to cement this as a key driver. So that's really what's been driving markets for the past few weeks is expectations that things will just be quite good on the macro front, especially by 2026.
So, Jason, with that set up in mind, the big story for this week is, of course, the Fed. It's universally expected that rate cuts will resume. But what else are you watching for?
I'd say it is all but guaranteed that the Fed will cut rates on Wednesday. The only real uncertainty is whether they cut 50 basis points or if they only cut to 25. Now, the market is pricing basically for 25 with a 10 percent, 15 percent probability for a 50 basis point cut.
There is an argument for them to be more aggressive. If you look last year, almost exactly a year ago, when the Fed cut, they cut 50 basis points. And partly it was because of the belief that maybe the economy is slowing and the labor market is kind of softer than they assumed.
Turns out the labor market wasn't quite as soft as they were fearing at that point in time. But do you think, given the current data, it's actually worse than it was last summer? Shouldn't this justify 50 basis points of cuts?
Well, one argument that they wouldn't is policy is also 100 basis points less restrictive now than it was a year ago. It's closer to neutral. It could be a little more methodical getting that back down to sort of a neutral policy rate.
Another factor is that inflation now is on the risk of kind of going higher in the near term, whereas last year it did look like it was continuing to kind of go lower. So both those sort of factors would justify the Feds that are doing 25 basis point cuts this time. The real focus will be on what does the Fed do going forward?
The market price right now is a little bit over 80 percent of probability that they cut at the end of October, and a little over 90 percent that they will end up cutting in the mid-December FOMC meeting. As you look into 2026, though, it becomes more dispersed in terms of where those dues shape out. A range of outcomes could play out.
Other things that I would sort of watch for in terms of this meeting that might indicate that path forward is the dot plot. This is the number of cuts that FOMC members think that the Fed will cut not only this year, but also next year in 2027. Given there's only two more meetings this year, whether it's two or three, including this week, implied number of cuts, I'm not sure that really matters that much.
The market's really going to focus on what do they do for next year. The Fed will also update its summary of economic projections for growth, inflation, and the policy rates this year. We're already now at the nine-month mark, and it looks like the data is sort of trending pretty much in line with what the Fed was forecasting back in June.
Shouldn't see a lot of changes there. The real focus will be on what Powell says at the press conference. He could say cut, but it sounds a little bit hawkish.
He's unlikely to give too much guidance in terms of the path going forward, but he could give his hand, similar to what he did at Jackson Hole, suggesting we need to be on a gradual path or clear path towards getting back to some sort of neutral policy rate, which the market would interpret as him endorsing cuts at every single meeting going forward. I'd have to take a very aggressive statement, I think, to kind of get the markets disappointed in terms of really a hawkish interpretation, and after the data that's come out since Jackson Hole, there's no reason for Powell to kind of sound more hawkish relative to Jackson Hole, but I think he could sound a little more dovish. Like our expectation, just to wrap up, is that the Fed will cut 25 basis points, and we'll have four straight meetings of 25 basis point cuts through the end of January, and perhaps a slower pace thereafter, so perhaps one more cut, but that is going to be very much kind of dependent on the economic data.
Well, the market pricing right now is for the Fed funds rate to get to a low of 2.8% by the end of 2026. A market pricing for sort of a neutral Fed funds rate is still around 3.75% to 4%. It's come down from where it was, but not nearly as much as what the market pricing is for the end of next year.
Ultimately, the way I kind of think about it, and from a market perspective and investing perspective, is that we know the beginning of the resumption of rate cuts this week is almost certain, but we don't know where the ending point will be. Not only when is the Fed going to be done cutting rates, like how long this whole cutting cycle will take, but also at what level should the Fed cut rates. And thinking about next year, the market performance, that's kind of really what matters.
There's a range of outcomes, but that's the key point to focus on, is the ending, not the beginning. Now, Jason, that's interesting. You say that the ending point for the Fed rate cuts is actually more important for the future market direction than this starting point.
So why is that? Well, the markets are already pricing in this cut. They're already pricing in a decent number of cuts the rest of this year.
But where do we kind of go from here? And ultimately, that sort of ending path of this rate cutting cycle, that's going to be a 2026 story. But the markets and investors are already kind of thinking about it, and it will become an increasingly part of the narrative that's driving markets as we get further into Q4.
As the data comes in, we'll get a sense of, is the economy holding up? Is growth slowing down, or the labor market slowing down even more? Or is it kind of stabilizing, and it looks like it's poised to accelerate next year?
Whatever assumption you want to make right now, in terms of the path going forward, it really embeds multiple different futures, meaning you're making some sort of implicit assumption about the likelihood of a recession, because the 2.8% market pricing for the Fed funds rate in the next year is not sort of a pure spot forecast. It has to price in some probability that there is a recession, and the Fed actually has to cut all the way to zero or close to zero some 1%. In a non-recession scenario, the market price would be more consistent with the public 3% to 3.25%, which sort of reflects that kind of view on a recession.
Any assumption you make has to be on the assumption of the stickiness of inflation, and whether it gets stuck around 2.5% or 3%, or the underlying trend is that it's still towards a disinflationary path that will allow the Fed to keep cutting. You have to make assumptions about Fed independence, and whether you change it just in Fed leadership with a new Fed chair, potentially three new members of the governing board. Does this tilt the Fed towards a structurally more biased perspective in keeping rates lower?
And so the question is about Fed independence because of political influence. And there's also the question, what is sort of a neutral rate of growth for the economy? What is the trend rate of growth for the economy?
Therefore, what is a neutral rate? The last one is the hardest one to answer. The Fed right now would say trend level of growth is a little bit below 2%, and neutral Fed funds rate of around 3%.
But if it turns out that the economy growth is solid, if AI leads to productivity growth, you could actually have a higher level of trend growth of over 2%, 2.25%. That would suggest that a neutral Fed funds rate is more like around 3.25% in that range. So 100 basis points of cuts will be sufficient.
You also have to make assumptions about what is the amount of term premium or inflation premium that investors will demand, which really affects more long-run rates. But that is a proxy for what the Fed might do with the policy rate because the more the back-end rates rise because of perceptions about a too-doublish Fed, that might argue for the Fed to do a little bit less to keep overall rates kind of lower. So there's a lot of things to kind of consider.
Ultimately, some of them could be good, like productivity growth that's higher leads to a higher neutral Fed funds rate. That's not a bad thing for the economy. It just means rates are higher because growth is good.
That's good for risk assets overall. A policy rate that's going much lower because of inflation or not because of slower growth, that's much more of a negative. And in some way, a policy rate that goes lower more because of concerns about political interference and a bias towards keeping policy rates loose, that might be a little bit better for growth, but it's also sort of more inflationary than being back into the curve.
The higher tenure yield is actually going higher, which may not be great for equities, at least as they sort of adjust to that logic. So that's why where we end up and why is probably more important to thinking about the market direction later into this year and certainly into 2026 versus the fact that the Fed is now cutting. I think that's already kind of well priced in.
It's the path and destination that matters more for market performance going forward. Now, Jason, based on all of these considerations, how do you recommend that investors be positioned at the moment? Well, near term, as I mentioned, the markets are pricing in.
I think a lot of good news. You expect everything to thread the needle, which does mean there's certainly scope for some volatility and pullbacks, especially given the run that we've had. But kind of zooming out to 12 months to maybe to the end of next year, ultimately, we believe that we are in a bull market for risk assets and for equities, that dips should be bought at this point in time.
If anything, for equities, it feels like the risk is skewed more to a bull case scenario. The markets can even amount higher as investors get sort of more bulled up as the macro conditions turn a little more favorable next year as the AI continues to play out. An investor position, as I mentioned earlier, is elevated, but it's really not stretched.
It's not like a full risk on situation like we've had earlier times just in the post-2020 period. Forget about the dot-com era that people often reference when they think about kind of bubbles in the markets. Within that, AI continues to be a key theme, a key driver, and the tech sector as a key beneficiary.
We saw that again last week with the reporting from Oracle. Financials and banks in particular should benefit from not only rate cuts, but an ongoing sort of deregulatory push. So, tilting within those sectors within equities overall.
In fixed income, the concern that we would have a little bit right now as the spread's very tight is taking too much credit risk. If you want to take risk in the markets, probably better to take it with an equity versus kind of corporate credit where you're just not getting paid to bear that risk. Rates have fallen a lot on these expectations that Fed's going to cut, but if it turns out the macro is okay, there's a pretty good risk that the 10-year actually backs up.
I'd remind our listeners that a year ago when the Fed cut, the 10-year was around 0.75%. It ultimately rose 100 basis points in subsequent months as the economic data turned out to be not as bad as investors feared. I wouldn't expect that level of rise in the 10-year after the Fed starts cutting, but certainly the risk is probably more that the rates go higher rather than significantly lower if the macro played as we expect with no recession.
All which is to say kind of shorting up duration at this point in time is the bias that we would have. Higher quality credits remains our preferred kind of way to play it, including things like agency investment, which I've done well. And agency investment is probably more so than corporate credit given that if there is risks to growth, it's a little more kind of government guarantee, a little bit safer asset class.
Gold continues to kind of glitter and perform very well. We think this as a diversification against some risks, but also probably first and foremost, the diversification against the US dollar. Gold continues to be a beneficiary and it is very much sort of a consensus view that's, you know, or anti-dollar is sort of a consensus view among investors.
If they're looking to deploy capital elsewhere, aside from other currencies, you know, the number one area that investors are looking at is gold, so we think it has a structural tail that will provide good diversification over time. So those are a few of the ideas that we like, given this macro backdrop, given what we expect from the Fed and the economic data to play out over the next few months and into 2026. Well, Jason, this was a great way to begin the trading week.
Thank you for dropping by, spending some time with our listeners, our clients, keeping them informed on CIO's positioning recommendations and for previewing the FOMC meeting for us that will give us something to talk about during our conversation next Monday. Until then, Jason, have a great week. You're welcome.
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