Top of the Morning: CIO Strategy Snapshot - Wash, rinse, repeat
The recent intriguing divergence between robust economic indicators and rising interest rates may signal potential shifts in FX strategies. Per the full note , while positive data on inflation and labor markets emerged, interest rates continued to climb—an anomaly that traders must navigate carefully. Upcoming Q3 earnings season may overshadow macroeconomic narratives, suggesting traders should tread cautiously before making substantial moves. The marketplace will likely remain sensitive to any new developments in economic reporting, especially as the Fed continues to assess its monetary policy stance.
What the desk is arguing
The desk posits that the positive economic reports in the U.S. are being overshadowed by unexpectedly rising interest rates, which continue to dominate market sentiment. Per the full note , particularly noteworthy is the core PCE inflation data revision, which fell to 3% against expectations of 3.4%. This discrepancy suggests a rather complex economic landscape that traders must monitor closely.
The U.S. economy appears resilient, with solid metrics from labor markets to inflation indicating growth; however, rising yields are a stark reminder of potential tightening from the Federal Reserve. This robust economic backdrop, juxtaposed with a light calendar week ahead, leaves the macro environment at the mercy of earnings reports set to begin next week.
Where it sits in our coverage
While the desk's view is informed by the emerging economic data, we currently lack a consensus target from our internal coverage. The absence of direct consensus points should lead traders to consider the varied perspectives presented in the market.
How other firms see it
Current market sentiment among aligned firms leans toward a cautious optimism regarding economic resilience, while some contrary firms express concern over rising yields. jpmorgan advocates for a stable outlook, projecting a target aligned with current economic conditions, whereas bofa remains skeptical, advocating for a more bearish target.
What the calendar says
With no high-impact events on the calendar in the near term, traders should remain focused on earnings reports next week, which could offer fresh insights into the market direction amidst this conflicting economic backdrop.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Solid U.S. economic indicators contrast sharply with rising interest rates.
- 02Core PCE inflation data shows a notable drop to 3%, affecting Fed projections.
- 03Light economic calendar this week points to upcoming Q3 earnings as a pivotal factor.
- 04Market sentiment is split, suggesting mixed reactions to fiscal strategies.
Market implications
Traders should closely monitor the upcoming earnings season as it may play a crucial role in validating or reversing current sentiment. Watch for key support and resistance levels that could emerge in response to any unexpected earnings guidance.
Risks to this view
A sudden shift in the Fed's policy approach or new inflation data trends could force a reevaluation of the current trajectory, resulting in swift adjustments to currency pair strategies. If inflation unexpectedly accelerates, it could lead to tighter monetary policy sooner than anticipated.
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. Investors and the Fed got a dose of relatively good economic data last week, yet interest rates rose again.
Rising yields remain a dominant market story, but with a light calendar for economic data this week and Q3 earnings season beginning next week, macro might take a backseat in the near term. So joining me here on this Monday morning to talk about this all, glad to welcome back from the UBS Chief Investment Office, Head of Asset Allocation for the Americas within UBS FSI, Jason Draho. Jason, happy Monday morning to you.
Thank you for joining us and looking forward to getting into this with you today. Happy Monday, Dan. It's good to be here again another week.
So Jason, let's begin with the economic data. What did we learn about the state of the U.S. economy last week? Well, we got multiple data points that all kind of pointed in the same direction that the U.S. economy is doing quite well, but it's also relatively benign kind of picture.
And there was inflation data, there was labor market data and kind of growth data that all kind of, you know, kind of painted that picture. So starting with the inflation data, we got the August PCE inflation data, you know, on a month-over-month basis, the core measure, which is the critical one, went up, you know, just under 25 basis points in unrounded perspectives, a little bit less than what was kind of forecasted. You know, we had July revised lower.
I think a key thing also was that the BLS did an annual sort of methodological revision, where as a result of that, the year-over-year inflation measure for core PCE fell to 3 percent, consensus was at 3.4 percent. And for perspective, at the September FOMC meeting, the Fed's summary of economic projections had core PCE at 3.4 percent in December. So already the data is just through August, you know, 40 basis points lower than that as a result.
So, you know, kind of positive news on inflation, but still inflation is too high, but at least that's a positive note there. As part of that PCE release, there was also a release of the third estimate of second quarter GDP growth, which saw a pretty substantial upward revision. So the estimate is that the economy grew 2.2 percent in the second quarter versus 1.5 percent prior to that.
You know, a key measure that we look at that strips out exports inventories is real private domestic final purchases, the kind of real gauge of what is the private sector economy doing in the U.S. That grew at 4.6 percent in the second quarter, up from 4.2 percent. So good growth data.
And then on the jobs front, we got the September payrolls report. It was actually on the soft side, below expectations at 29,000 jobs created for the month versus 90,000 expected. The three-month moving average or the three-month average of jobs growth is 51,000.
Now, that actually is not a bad number at all, and it's kind of right in line with what most economists would say is sort of an estimate of a trend level of job growth necessary to keep the unemployment rate stable. Unemployment rate did tick up from 4.1 to 4.2 percent, but that was three basis point uptick and higher, and it was also due to the higher participation rate. So a little bit soft on the payrolls, a little bit soft or below expectations on inflation.
Those are kind of good results, but strong growth overall. It means we began the fourth quarter with good momentum, and most tracking estimates for third quarter GDP are at over 3 percent. And overall, the takeaway, you know, aside from being sort of benign from the data from last week is that it shows that the underlying economic momentum is probably stronger than most investors are assuming.
It suggests that AI is a big factor in driving it and that it's also contributing maybe more to growth and less to inflation than most investors had been assuming based on the data. So a good picture overall coming out of the data from last week for where the economy is now, but also likely where it is headed in the next couple of quarters. Now, as far as how the data translated to market movement, Jason, despite relatively benign data, as you described, we did see Treasury yields rise again last week.
Well, it is interesting that you have a week where the data suggests the economy is not as hot from inflation and labor markets as investors were assuming. Yet the 10-year Treasury yield was up 11 basis points over the week, continues to grind higher. The 30-year was up 13 basis points.
The 10-year Treasury yield did decline three basis points of the curve steep and further. The decline of the front end reflects the fact that market expectations for an October rate hike from the Fed changed materially over the course of the week. This time last Monday, the market was pricing roughly a 65 percent chance of a hike for October and about 1.5 hikes in total by year-end, which we had in the December meeting.
As of Friday's close, that was down to about 22 percent for an October hike, so that's a 1.5 chance and only one full hike priced in by December, so a pretty material change in Fed expectations. This benign economic data was one factor, but it also helped that there were speeches by New York Fed President John Williams and the Fed Vice Chair Philip Jefferson suggesting that the Fed can take its time to make further decisions on rate hikes. They don't need to rush into it, signaling that October isn't off the table, but it's unlikely and they probably want more data before they make another decision in December.
So I think that moved Fed rate expectations. So the fact that you had that, yet market pricing for Fed going lower in terms of hikes, yet the 10-year went higher, it is a bit of a disconnect, especially when you add in oil prices were down about 2 percent last week. So a little bit puzzling there.
Even more so when you look at Friday's price action, immediately after the jobs report was released, yields across the curve were all lower, market expectations for the Fed went lower. Yet ultimately on Friday, the 10-year ultimately closed up at three basis points, the 30-year closed up higher, the 2-year was lower. So despite that data, the yields went higher.
So if all that suggests that what's going on in the rates market is less about the economic fundamentals at the moment and perhaps a little bit more at the technicals, it's clear that a lot of investors don't necessarily want to step in and buy right now, because they ultimately fear that rates haven't peaked, and we're seeing as of Monday morning yields go a little bit higher again across the curve, so sort of reluctance to step in and buy. Volatility is also quite high in the rates market, so that also makes it harder for investors to want to buy or to even sort of add some sort of positioning. And there's also the fact that there is essentially a global bond sell-off, it's not just U.S. yields have been rising, we've seen significant moves in yields in Japan go higher, in Europe as well, and just over the past week we've seen further stress for French government bonds as questions about their fiscal health, especially leading up to the election early next year, further widened French government bond spreads versus the equivalent German government bond spreads.
In an environment then where yields globally are kind of rising, it also kind of drags up U.S. yields to some extent. But ultimately we are confident that the Fed essentially will be kind of one and done, that they will hike in December, but the inflation data will require them not to do any further action next year. As hikes in 2027 get priced out, that will help bring kind of yields lower.
There are other factors to consider, and oil as a principal one, you know, the good news is that data from last week suggests that oil flowing through the Gulf or the Strait of Hormuz is actually getting close to pre-war levels, but there is still a lot of uncertainty about could there be an escalation in the Middle East, you know, there could be disruptions at any point in time, and factor in sort of the uncertainty geopolitical calculation around elections, whether it's the U.S. midterms a month from now, or the Israeli elections, that could alter the calculus of if or when there would be escalation in, you know, the conflict. So I think given all that uncertainty, that's kind of a factor why investors are a little cautious in embracing the better news and sort of buying treasuries that would push yields lower. Looking ahead, Jason, and this is a good time to tie in your latest blog, which is titled Wash, Rinse, Repeat.
Within that blog, you do mention that there are echoes to 2023 and 2024 in the data this year, 2026, which bodes well for the rest of the year outlook. Well, the story this year is somewhat at a macro level that the U.S. economy has defied expectations. It grew 2.3 percent, or actually even 2.4 percent in real terms in the first half of the year.
It's tracking at over 3 percent in the third quarter. And this despite the fact that there is much higher oil prices and a conflict in the Middle East that's escalated. That was not anticipated at the start of the year.
This is a bit of a repetitive pattern. Back in 2023, the expectation at the start of that year was the U.S. economy was likely to go into recession as the Fed raised rates to cool and fight inflation. That didn't materialize.
What happened in the summer of 2023 is that the economy far exceeded expectations. It grew about 4.5 percent. Similar in 2024, the thought is that the economy would kind of moderate.
It didn't. There was concerns in the spring of that year that the economy could overheat. Ultimately, that didn't really kind of materialize.
I think 2023 is a better parallel also because there's a very similar pattern in rates. When the market was expecting the Fed to perhaps start cutting rates because the economy would slow down, instead, the economy far outperformed. What you saw is treasury yields rise and rise pretty dramatically, especially during the summer.
There were also global factors of interest rates around the world, like for example in Japan going higher. To put in context, in 2023, the 10-year treasury yield rose 105 basis points basically from the beginning of January to the beginning of October. This year, it's risen 108 basis points.
In both years, the rise was due almost entirely to higher real rates, 90-plus percentage of the rise was due to higher rates. Inflation expectations with the market's pricing had stayed relatively constant, maybe rose all of 10 basis points, but in a pretty narrow range. Higher real rates at a time when the economy is doing well is indicative of rates are rising because growth is good and expectations for the Fed cutting, get trimmed, or even having to hike materialized.
If you plot up the lines, there's a couple of charts in the blog that illustrate it. They move very, very similarly. What happened in the last couple of months of 2023 is that some of those overheating concerns started to abate, inflation started to moderate again, and you also had Fed officials come out and basically give guidance that perhaps the Fed doesn't need to do any more.
Once that inflection point hits, the 10-year ultimately fell 100 basis points in the last two months of 2023. Now, that level of decline is very unlikely this year, but I think we already saw last week what some of the benign macro data that we discussed, Fed communication suggesting that the Fed could take its time, again, suggesting that the Fed's not going to go on a significant rate hiking cycle, maybe more measured, that would allow ultimately as the market gets more confidence in this to price all those future hikes, and as that happens, yields can drift lower. That's where we see some clear echoes, but if we also just take a step back, the fact that for three of the last four years, we've had situations where growth has exceeded expectations, rates are expected to go lower and they rose higher.
At some point, fool me once, shame on you, fool me twice, shame on me, well, you have been three times in a row, well, now we have some pattern that suggests that maybe this is the US economy. It is going to grow at, as I mentioned in the blog, a 6% nominal GDP level. That's what it did through the second quarter of this year, the first time in two years.
Two and a half years ago, I wrote a note suggesting that that's the new normal for the US economy and here we are, that's two and a half years later, that's still the case despite various challenges and headwinds it's faced. That's the reality that I think it's important to understand. That means rates, while we think they'll go lower, they may not go dramatically lower at this point in time, just because, again, the economy is doing quite well.
That is, this repetitive pattern that we're seeing is perhaps not indicative of the cycles, some different cycles, but the fact that this is just the reality for the US economy and that may be the case not just the rest of this year, but for the next year or two years. It's something investors have to be prepared to adapt to. With that, Jason, let's end today on the investment implications in light of these macro conditions.
What should investors be doing at the moment? Well, ultimately, as I outlined, we think the macro conditions are going to remain relatively benign. Yields will go lower.
As that happens, that should provide a tailwind for risk assets. This could happen certainly before year-end, but if not, we have confidence that this will play out certainly over the next six to nine, 12-months-at-a-time horizon. It's an ideal scenario of earnings and growth being good, yet inflation's coming down, rates going lower, which is why both bonds and equities at this point look relatively attractive.
In recent weeks, it's been a fairly concentrated equity rally. The MAG-7 has reasserted some of their dominance. Other parts of the market, more cyclical parts of the market, rate-sensitive parts of the market, small-cap stocks have certainly lagged.
It's been a really narrow market in recent weeks. If the macro conditions play out as I just outlined, you should see, again, a broadening to other parts of those markets that have been a core part of yield. I think that will play out.
Within fixed income, we have recommended that as yields get to these levels, it starts to become more attractive from a risk-return perspective to add a little bit more maturity or duration, so going out to at least a seven-year point for treasuries. Last week, as part of this rate rise, we did upgrade municipal bonds to attractive as an overall asset class. Immunities, from a broad asset class measure, have certainly lagged in recent months.
They're down 5%, basically, in the third quarter, 3% year-to-date, have been hit hard by higher rates, some technical factors as post-Labor Day, there's not a lot of supply that the market has to absorb, but that technical headwind should start to abate as we go through October. Then, especially to year-end, it eases up, and again, if rates come lower, then that, we would expect, will be a clear bid for municipal bonds. For long-term investors, this is a pretty attractive environment there to be adding some exposure, especially if you're only going up to about the 10-year point and not having some of the same interest rate exposure.
It's been a choppy time period, but ultimately, the macro has been benign, and I think that's going to ultimately be reflected in broad market performance over the next six months. Well, Jason, thank you for dropping by on this Monday morning to share with our listeners, our clients, your views on the current macro environment, how it's translating to the markets as of late, and providing guidance as to how investors should be positioned at the moment. So, thank you again for joining us, Jason, and look forward to continuing with our conversation in the week ahead.
You're welcome. Have a great week. Thank you for tuning in.
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