Top of the Morning: CIO Strategy Snapshot - Being Kevin Warsh
In light of the recent Fed rate hike, the desk views the short-term outlook for the dollar as cautiously optimistic, with an expected pause in the tightening cycle post-December. Per the full note from UBS, uncertainties remain—a stable U.S. economy is coupled with ongoing geopolitical tensions that could sway investor sentiment. The potential for only one additional rate hike this year implies a shift in market dynamics, suggesting that traders should brace for volatility driven by economic sentiment and geopolitical developments. Moreover, the market's anticipation of a likely rate cut in Q3 2024 creates an interesting scenario for dollar strength in the interim, balancing risk against opportunity.
What the desk is arguing
The desk's thesis is that the Federal Reserve's recent rate hike will elevate the dollar’s strength, albeit temporarily, as uncertainty remains a consistent theme in the markets. According to UBS, the Fed's decision to raise rates was straightforward given the current economic landscape where core inflation runs above 3% year-over-year, alongside resilient growth indicators.
Moreover, with their prediction of only one more rate hike—projected for December—followed by an extended period of stability, traders should be mindful of the 50% probability in the market for a potential hike at their next meeting, highlighting the delicate balance between growth and inflation risks.
Where it sits in our coverage
Currently, the consensus target for the EUR/USD is set at 1.075, with a range between 1.04 and 1.12. Specifically, jpmorgan holds a target of 1.10 for March 2026, indicating a more bullish outlook compared to bofa, which expects a lower 1.04 target for the same date.
This positioning suggests the desk’s view aligns closely with the upper bounds of the consensus, reflecting optimism about the dollar in the context of global uncertainties balanced against domestic economic performance.
How other firms see it
Aligned firms such as jpmorgan maintain a positive outlook on the dollar, forecasting higher levels against the euro, while contrary views from bofa reflect a more cautious stance focused on potential downside risks.
Monitoring the USD/JPY pair may be insightful as it closely follows Fed policies, amplifying the implications of the current rate decision on broader markets, especially amid a stabilizing U.S. economy.
01The Fed's recent rate hike reinforced expectations of dollar strength but uncertainty remains due to geopolitical factors.
02Market anticipates only one more rate hike in December, with the next pivot likely a cut in Q3 2024.
03The current economic outlook is resilient, with core inflation above 3% year-over-year, sustaining market interest.
Market implications
Watch for fluctuations in the USD as traders react to global geopolitical tensions and domestic economic data releases. The upcoming December Fed meeting will be pivotal in shaping market perceptions and positioning.
Risks to this view
A significant shift in geopolitical stability or a major economic downturn could diminish confidence in the dollar, potentially leading to a reassessment of the current bullish stance. Any unexpected dovish signals from the Fed could also rapidly reverse recent dollar strengthens.
ubs
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. After months of speculation, the Fed finally raised rates last week.
That removes one source of uncertainty in the near term, but there are still many other risks to occupy the minds of investors, including those related to geopolitics. Meanwhile, the U.S. economy continues to perform quite well. Joining me here at the 1285 podcast studio in New York on this Monday morning for the CIO Strategy Snapshot.
Glad to welcome back Head of Asset Allocation for the Americas from the UBS Chief Investment Office within UBSFSI, Jason Draho. Jason, good Monday morning to you. Great to be back at the table and looking forward to our conversation here today.
Good morning, Dan. Good to be here. Happy Monday.
Happy Monday. So Jason, let's begin with the Fed since that was the big event last week. Our listeners may recall we spoke about the FOMC on last Monday's episode leading up to the rate decision.
The Fed did hike rates as expected. So the question now, Jason, is where does the Fed go from here? Well, I'd like to say we nailed the call last week, Dan.
Although I think it was a pretty easy call and a pretty easy decision for the Fed to hike last week. If you look at the economic conditions, growth has been quite resilient. The core PEC inflation measure that the Fed focuses most on, it's running at over 3% year over year.
And the market was pricing a nearly 95% chance of them hiking. So I think that was an easy decision. So really, where do we go forward from here?
Now, just to level set, our view in CIO is that we expect one more Fed rate hike. That's going to be in December and then sort of an extended pause well into 2027 with the next boom being a cut, let's say, probably later in Q3. But a year from now, that's a lot of uncertainty.
If we compare that then with market pricing, market pricing has about a 50% chance of a hike at the next meeting, which is the end of October. It happens to be six days before the midterm elections. And so for political optic reasons, we would think, I think most people think that it probably won't happen then.
Even if you believe you need to raise rates to tighten policy, you might want to go a little slower, which is why also the market then would have ultimately one full hike priced by December. And over the next 12 months, three full hikes. So definitely more aggressive than what we have.
But also the Fed's summary of economic projections, there is a dot plot of what the different FOMC members think. And the median of that dot is one more hike this year, but then no hikes next year. Ultimately, what will happen with Fed policy depends on the data and the inflation data.
And ultimately, we think it will get better the rest of this year until in 2027. And this will begin as soon as September 30th when the BLS will revise numbers based on a different methodology of how to calculate certain components of the inflation index. And that could drop the year-over-year numbers upwards of 20 basis points.
So already kind of a step down and then kind of trend in there. But one of the key questions ultimately is what does Fed Chair Kevin Walsh think? He's given a hawkish speech at Jackson Hole at the end of August.
His comments at the press conference last week were certainly hawkish. That's the market consensus, market commentators, that this was a hawkish outcome. But without really knowing his true reaction function, it's one thing to say things, but what does he really believe?
So we can all be kind of speculating. And I wrote a blog that was just published overnight titled Being Kevin Walsh, a play on the movie Being John Malkovich. If you recall this from 1999, the idea is one of the characters, John Cusack's character, stumbles upon a portal into the mind of John Cusack or into John Malkovich.
So I think investors would probably welcome a chance to kind of portal into Kevin Walsh's mind to understand like what does he really kind of think? Because we are now in the realm of interpreting his comments, trying to infer what he thinks. There's a couple of things he said during the press conference that could kind of go in different ways of how you want to interpret it.
For instance, on three different occasions during the press conference, he made a comment that they were removing a dose of accommodation. Now, some could view this as evidence that he believes that current policy is accommodative, meaning the Fed funds rate is actually below neutral. So you have to hike rates not only to get to neutral, but above neutral to be restrictive to bring inflation down.
That would imply multiple cuts. But does he actually believe that or is it just like he misinterpreted how people would interpret that particular line? It's unclear.
He was also asked by a reporter about the inflation target in the summary of economic projections. The forecast is inflation will get to just over 2% by the end of 2028, so over two years from now. Does he think that's accurate or not?
He said that's not my forecast. So does he think inflation will get there faster or slower? Because if it's faster, it means less is necessary in terms of tightening policy.
If it's slower, then you've got to do even more. Ultimately, I think the other view that – and this is again a conjecture trying to be Kevin Warsh – is that ultimately, we think that financial conditions don't really need to tighten significantly to achieve the investment objective. If that's the case, it ultimately is a good thing for the financial market outlook.
But that is kind of one of the unknowns right now. There's a lot open to interpretation at the moment, Jason. You did mention that economic resiliency is one of the reasons why the Fed was able to hike rates last week.
So from your vantage point at CIO, how is the economy looking at the moment? Well, it was economic resilient and it's also if the economy continues to be resilient along the lines of where it has been, it gives it a further case for the Fed just to keep hiking because that would suggest that policy is not restrictive at all if we continue to grow at nearly 3%. And just on that point, we got data on Wednesday, earlier in the day before the FOMC decision.
It was August retail sales data. They came in well above expectations. There's different components to the retail sales report.
What tends to be most important for economists is looking at the kind of the control group that factors out or removes spending on gas, groceries, things that can be kind of very volatile based on some price fluctuations. The control group came in at 1.4% growth month to month in August. Consensus expectations were 0.5% and then in prior months had been revised higher.
So very strong numbers for retail sales. This is one of the factors why nominal consumer spending on a year-over-year basis is up over 6%. So very strong kind of retail spending numbers.
This despite the fact that there is evidence of a K-shaped consumer and people kind of point to it. But in aggregate, the consumer is doing quite well overall. You couple that with a labor market that looks like it's, if anything, kind of accelerated a little bit from earlier this year.
The August payrolls report was better than expected. The three-month moving average of payrolls growth is about 71,000. Consensus view of like what is the break-even number, how many jobs need to be created every month in order to keep the unemployment rate steady.
Estimates vary from like 0 to 60,000. So certainly on the high end of that range. And just last week on Thursday with the weekly initial jobless claims, it was only 196,000.
Very low number. Shouldn't be an obvious kind of seasonal factor that would kind of destroy the numbers lower. You take the four-week moving average, just over 200,000.
This is basically the lowest level it's been in the last three years. So solid labor market despite various concerns, solid consumer spending. It's not surprising then that third quarter GDP tracking estimates from economists are around 3%.
The Atlanta Fed, that's kind of why they fall. It has its own GDP now forecast. That's closer to 5%.
A little bit distorted because of trade, inventory matters, but the underlying sort of private sector final demand looks quite resilient. So good strength there. So yes, inflation is elevated.
There's supply side factors to it, but this is also a sign that the demand is quite resilient. So one of the components I think where prices went up last month was like cell phone service plans. Hard to say it's a supply side issue.
That's a sign of consumers being relatively strong. So it's a good thing that the economy is resilient and growth is solid. It does also raise the question if growth continues along this path and inflation is over 2%, does the Fed stop at one more hike or does it do more?
So there's a kind of good and bad with strong growth that if inflation continues to be elevated, the Fed can keep hiking. And what the data is telling us, Jason, the economy, U.S. economy in good shape and the Fed rate hike we witnessed last week seems to underscore that. Yes, correct.
So rising interest rates, Jason, as we've talked about over the past few months have been a dominant market story. After the Fed hike last week, what is the latest CIO investment recommendation for fixed income? Well, the Fed meeting, the hike happened to be the house view week where we updated our house view and one of the key messages there, kind of all told is that ultimately within fixed income, we think there's good opportunities but this is a chance to maybe further extend sort of the duration that you're targeting in your portfolio if you're looking to add exposure within fixed income.
The rationale for that is, again, going back to some of the market pricing, we think the Fed does one more hike. The market is pricing for three more. If our view proves to be correct, even if it's closer to the market, the market is kind of already priced for that, which suggests that yields don't necessarily have to go much higher.
We ultimately think they're kind of at the high end of the range and they will drift low over the next six to 12 months. If that's the case, that's kind of good for fixed income in general but it tends to be even more beneficial for longer duration fixed income because they're more sensitive to moves in rates versus a two-year treasury yield. So the message we've had for a while is because we were concerned that rates could go higher, it would cause, at least on paper, losses, price losses as the yields go higher at the back end of the curve.
Now that the yields have risen a lot, this is a chance actually now, the risk war, we think, to kind of extend that duration. So instead of aiming for around a five-year or less maturity, five to 10-year looks more interesting if you want to add higher quality fixed income to kind of add that exposure. Going beyond 10-year, if you're looking all the way up to 30-year, other factors, whether it's oil prices, concerns about debt sustainability, long-term inflation concerns, it's a little more unanchored but that's why we sort of avoid taking a lot of exposure there.
But by and large, the idea of extending duration given where the rates are, the risk-reward of adding that longer exposure looks a little bit more attractive now. I think the biggest risk to this, at least in the near term, frankly, is oil prices. If we were to plot a chart of the 30-year treasury yield and the price of oil like WTI or Brent, they've moved in pretty parallel passion since the spring.
We've seen, even in the past couple of weeks, as the situation in the Middle East escalated, more fighting, more concerns about oil supply, prices going higher, yields are going higher. As we've seen a bit of a reprieve for oil prices and even this morning, Monday morning as we're doing this, oil prices are a couple of dollars lower. We're seeing treasury yields down three or four basis points.
So if the situation de-escalates, that's positive for rates, all is equal, enhancing our view. But there is certainly a risk that they could escalate and they could cause a more significant dislocation and disruption in oil prices. And aside from the fixed income updates, Jason, looking at the house view, which again now available on UBS.com slash CIO.
What are some other key messages in the update from CIO? Well, the overall messaging hasn't changed very much. It's still relatively constructive on risk assets.
Last month, we kind of changed the messaging to like a position for upside inequities. We continue to think on a, again, sort of more of a 12-month view. There is good upside.
A lot is predicated on the fact that what economic growth has resulted, high nominal consumer spending, high nominal GDP growth. That translates into high nominal revenue growth and that translates into higher earnings per share growth. It's why we expect right now earnings growth of 14% in 2027, after 2026 where it's likely to come in close to 30% and we're a few weeks away from the start of Q3 earnings season.
A lot of concern about AI investments, but it's probably not going to be overly sensitive to higher rates. We continue to expect over $1 trillion of spending next year on investment, again, supportive for earnings and for equities overall. So all that is positive for equities.
Higher rates certainly pose a risk, but again, the markets are already pricing for the Fed to hike multiple times. We've seen on Thursday of last week and even against the Monday morning, despite those higher rates, equities can be quite resilient again if oil prices go lower, but also as long as economic growth is solid and earnings growth is solid. So kind of positioning for that upside, it's kind of broadening out, it's kind of exposure both in the U.S. and global that remains kind of a key message.
And I think sentiment got a little cautious going into the Fed meeting, positioning data would suggest investors have lightened up. So from a technical sentiment perspective, I wouldn't say it's overly kind of bullish and constructive, but it's not a headwind in the near term for equities to kind of move higher. But like with rates, oil, I think that's probably the bigger sort of near-term risk.
There are other geopolitical factors besides the Middle East with President Trump and President Xi of China sort of meeting this week, some concerns about AI, there could be some anxiety going into the midterm elections in terms of policy changes. But ultimately, I think the key thing over time what drives the markets is economic fundamentals and those look quite solid. And the last thing I'll say is gold is something that we've kind of liked in terms of as a portfolio diversifier, had a strong August, pulled back a little bit.
But again, if rates kind of drift lower, I'll say that is on a more medium-term view kind of constructive for gold to provide sort of balance and diversification to your portfolio. Jason, very helpful insights here in your takeaways from last week's FOMC meeting with the Outlook for Monetary Policy could consist of as we'll continue to monitor it and with the UN General Assembly in session this week, just a few blocks away from where we're recording here at 12.85 will be interesting to hear if anything comes out of those meetings and how the markets may respond. That is a good reminder to avoid midtown traffic and try not to go across town the next few days.
I was on foot this morning and will be the entire week. Very good. That's the way to do it.
Jason, thanks again. And do want to point out Jason's blog, which he mentioned on today's episode. That title being Kevin Warsh, available now up on UBS.com slash CIO, along with the latest UBS House View publication suite, which was mentioned as well from UBS Studios.
I'm Dan Cassidy. Thank you for joining us. Thank you for tuning in.
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