Last week, the European Central Bank and the Bank of Canada each lowered their respective policy rates by 25 basis points, as widely expected. However, the ECB and BOC offered slightly diverging guidance. The ECB significantly revised its growth forecast for 2024 (by +0.3% to 0.9% growth) and emphasized a data dependent stance, failing to provide strong guidance for future rate cuts. Conversely, the BOC offered dovish guidance, signaling further cuts if inflation continues on its current trajectory.
In response, global bond yields fell and financial conditions eased. The US 10Y yield fell 21 basis points on the week through Thursday, before the strong jobs report on Friday sent the 10Y yield up 15 basis points on the day.
Non-farm payrolls rose by 272k in May, reversing the low job print of 165k from April, which was revised lower from 175k. Job growth has now averaged a healthy 255k over the past six months, and last month’s job gains were broad-based across nearly every industry rather than concentrated in the government sector, as they have been in prior months. Coupled with job openings declining by 296k in April to 8,059k, the labor market is normalizing at a healthy pace; job openings to total unemployed continues to trend lower and is closer to pre-pandemic levels.
The stronger-than-expected job numbers contribute to the conundrum facing the Federal Open Market Committee (FOMC) this week: normalizing the policy rate by gradually bringing it closer to the FOMC’s longer-term neutral rate of 2.5% risks fueling an already-strong economy and reversing the downtrend in inflation. To complicate matters, May CPI figures will be released on Wednesday, and expectations are for CPI and core CPI to have declined.
We are not expecting any explicit policy changes from the Fed, and instead will be focused on changes in the Fed’s dot plot. Based on recent data and Fed communication, the dot plot should indicate two rate cuts for 2024, falling from a median of three cuts indicated during the May meeting. The dots could potentially surprise to a more hawkish side if only one rate cut served as the median, or if the number of voters supporting one rate cut was more than expected. The May FOMC meeting minutes stated that “various” members are considering a rate hike as the next step, which presumably means they are not going to support two cuts in 2024 with the recent data readings. Nonetheless, Fed communication has been effective as markets have priced in a less dovish Fed outcome in 2024 with very little volatility in credit and equities.
Nonetheless, we continue to believe that as long as the next policy shift remains an interest rate cut, fixed income remains extremely attractive on a risk-adjusted basis versus nearly every other asset class. The distribution of outcomes for bond yields remains asymmetrically skewed to the downside as the world’s central banks continue to embark on an interest rate normalization process, which, for every central bank except the Bank of Japan, means rate cuts.
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