Federal Reserve Impact on Markets

The market’s fortunes reversed this week as Treasury yields fell sharply and the S&P rallied to its best week of the year. What drove this sudden reversal? The bottom line is the market became less concerned that rates will stay higher for longer…for longer. This shift in sentiment started when the Treasury’s refunding announcement came in lower than expected and alleviated some concerns around supply as an ongoing technical headwind. The next domino to fall was the #FOMC meeting and press conference. While the policy decision to keep rates unchanged was in line with expectations, markets found dovish tea leaves in the fact that Chair Powell acknowledged tighter financial conditions. And finally, all eyes turned to today’s #jobs data for confirmation that the economy was slowing in a healthy way. And it delivered just what investors were looking for. Overall, these developments support our view that 1) the Fed tightening cycle is over, 2) the #economy is headed towards a slowdown and softish landing, but not a recession, and 3) Treasury yields will trend lower towards 3.5% by the end of 2024. Read more about what this means for positioning in this week’s regional view.

If long-end bond yields spiral out of control, the Fed could start injecting liquidity again: a step-by-step guide of how it works. When a few weeks ago 30-year bond yields briefly flirted with the 5% level, the Fed's Collins released an interview stating that ''the Fed is absolutely ready to stabilize markets''. To stabilize the bond market, they would ''inject liquidity'' through operations like the LSAP - Large Scale Asset Purchase or QE. Central Banks create bank reserves when they perform such operations. Bank reserves are often referred to as ''Liquidity''. When Central Banks engage in liquidity creation, they do that in the hope that it activates the so-called Portfolio Rebalancing Effect. To understand this, let’s start from what QE does to the balance sheet of a commercial bank - take a look at the chart below. Following the GFC, regulators forced banks to own more HQLA (high quality liquid assets) to meet depositor outflows. Bank reserves and bonds qualify as ''HQLA'' as they are liquid enough to be converted in cash to meet potential outflows quickly. But banks are not indifferent between owning bank reserves and bonds, and especially if the amount of reserves grows dramatically as a result of QE. Bank reserves are a zero-duration and low-yielding instrument which can be suboptimal to own in big sizes especially if compared with bonds which offer higher returns and duration hedging properties. And this is when the Portfolio Rebalancing Effect kicks in. Once QE starts, Central Banks take away bonds and inject new reserves in the banking system. Loaded with suboptimal reserves, banks will try to switch back the composition of their portfolios towards more bonds. They will bid up safer bonds first, and bid up riskier bonds later when the hunt for returns intensifies. This will kick in a virtuous cycle of low volatility and a hunt for riskier assets: the Portfolio Rebalancing Effect in action. Summarizing: 1️⃣Central Banks expand their balance sheet and purchase bonds 2️⃣Commercial Banks are on the receiving end of QE, and hence their portfolio composition tilts towards more reserves, and less bonds; 3️⃣But reserves are sub-optimal to own compared to regulatory-friendly bonds, and hence they look to rebalance their portfolios; 4️⃣They start buying the very same bonds QE is buying, hence suppressing volatility further and compressing credit spreads; 5️⃣Asset allocators and investors across the world are more and more encouraged to take additional risks in their portfolio, supporting the flow of credit and capital. Does the Portfolio Rebalancing Effect make sense to you? 🖊️ Alf, Founder & CIO of macro hedge fund Palinuro Capital 👉 If you enjoyed this post, follow me (Alfonso Peccatiello) to make sure you don't miss my daily dose of macro analysis.

Recent equity rotations reflect a downgrade to the market’s outlook for economic growth, but the prospect of Fed easing has left the S&P 500 near its all-time high. Our economists forecast the Fed will cut by 25 bp for the first time next week and expect 200 bp of easing through 1Q 2026 (vs. market pricing of 260 bp). But the trajectory of growth is a more important driver for stocks than the speed of rate cuts. The offsetting valuation impact of higher bond yields and better growth expectations imply limited scope for P/E expansion. With multiples flat, EPS growth will lead the S&P 500 modestly higher. Our year-end 2024 S&P 500 price target remains 5600. Our rolled 6-month and 12-month price targets are 5700 and 6000.

The Fed Hasn’t Eased, But Markets Have: Financial conditions are the strongest they’ve been in years (see chart below). Capital flows and credit markets are highly supportive by economic growth, signaling minimal risk of recession. Corporate obligors are able to refinance their debt with coupons that are ~50bps lower y-t-d (BSL market has enjoyed record refinancing during the summer of ’25), the equivalent of the Fed easing 2x (despite the Fed not actually easing as of yet). Recent PMIs indicate a vibrant economy as companies are reporting record earnings that are pushing equities to ATHs. There are no signs of slowdown, just TINA - so stay invested. With the Fed soon to begin a new easing cycle, even more liquidity will only serve to bolster investor confidence. Credit investors will benefit from the resurgence in new issuance, as deal activity is creating a rich opportunity set for credit investors. Refinancing not only extend the maturity runway, but also enable companies to lock in a lower costs of capital. Private Equity sponsors have focused on asset management over the past three years as monetization slowed, however, that too is changing as there is a resurgence in M&A activity, which creates significant investment opportunities for private credit lenders. This surge in activity is offering attractive entry points across the capital structure, particularly in higher-quality credits where direct lending spreads remain compelling relative to fundamentals. For capital allocators, it is safe to lean in, capture yield, secured by strong covenants, while participating in transactions that are benefiting from both healthy balance sheets and a favorable macro backdrop.

A jumbo rate cut from the Fed. The statement accompanying the Fed’s 50bp rate cut recognised both the “progress on inflation and the balance of risks”. While, in the press conference, Powell confirmed that “labour market conditions have continued to cool”, and that makes it time for an “appropriate recalibration of policy” So the soft-ish landing 🛬 is coming into view. The Fed’s forecasts reflect a clear endorsement of that scenario: 1️⃣ the unemployment rate picking up but remaining low, 2️⃣ GDP growth seen settling at 2%, and 3️⃣ inflation is back on target in 2025. Of course, this is all something that many investors have had in mind for a while How fast will the cutting cycle progress and where will it take us? Traders are now assuming another 70bp worth of cuts before year end. And Fed policy is now priced to dip below 3% by mid 2025. Quite rightly, Powell would not be drawn into policy pre-commitments – simply that the Fed would move “as fast or as slow” as needed. But, reading between the lines, the idea here is to get policy back to its neutral setting of, say, 3-3.5% in reasonably quick order 📉📈 In markets, lower bond yields, a weaker dollar, and higher stocks was the high-level result. Importantly, market dynamics are beginning to reflect the soft landing playbook. 1️⃣ The US yield curve (spread between 2 and 10y bond yields) has been bull-steepening and is back in positive territory. 2️⃣ Credit spreads remain close to multi-year tights, with US high yield spreads in the low 300bp. 3️⃣ And the stock market is broadening out – the equal weighted S&P500 is now outperforming the market cap index, small caps are beginning to hold their own versus big caps, and emerging market stocks are also finding their feet Can it last? If policy makers can get the soft landing to stick - and avoid labour market cooling becoming labour market freezing 🥶- then those trends can extend 🗺️ The soft landing playbook is for a “great rotation” in markets, with value, small caps, and EM outperforming. And for a “structural steepener” of the yield curve. Today’s Fed decision improves the odds of sticking the soft landing. But with policy rates still restrictive, monetary easing likely to take some time to feed into the real economy, and fiscal policy now a mild drag on growth, recession risk will remain elevated for a while yet ⚠️ We expect a more volatile environment in investment markets in the remainder of 2024. Economic and political uncertainties are coming to the fore during Q4, and that seems likely to drive turbulence in investment markets. But today’s jumbo Fed cut is a good start to allay some of those fears… #economy #fed #centralbanks #investing

✂️ HOW STOCKS RESPOND TO RATE CUTS ✂️ (it's not what you think) People like to paint rate cuts as this path to universally lower rates everywhere and a stock market boom. This isn't always the case. The market response to rate cuts depends on the context of the cut. Yes, technically, the stock market does well after a rate cut if you average out 12-month returns. The S&P 500 has risen an average of 11% in the 12 months following every rate cut since 1970. But if you look at Fed cuts rates during expansions that don't preclude a recession in the following 12 months, the S&P 500 has been up an average of 13% over those 12 months. These are celebration cuts. Growth gets a boost, the economy stays afloat, everybody is happy. However, when the Fed cuts rates during expansions and a recession does materialize, the S&P has dropped an average of 11% over the following 12 months. And historically, more often than not, this scenario has led to a nasty crash in prices. These are desperation cuts. Cuts that are needed because the economy's already in a bad spot. The chart below illustrates the differences in outcomes for different rate cut cycles (a little different, as we’re not technically starting a rate cut cycle right now). Same takeaway, though – every rate cut is built different, and we shouldn’t assume the path forward will be easy. The economy’s future path matters more than Fed policy. That’s why it’s a mistake to ignore mixed signals right now, especially when the job market is flailing. Invest, but don't get too carried away.

Tariffs Take a Toll on Services, Raising Fresh Stagflation Concerns   Service-sector activity contracted in May for the first time since June 2024, confirming our expectations ahead of the Institute for Supply Management’s report. We were one of only two forecasts anticipating a decline—and the reason was clear: tariffs.   Long seen as shielded from trade-related headwinds, the service sector is now feeling the impact. Businesses cited rising input costs and heightened uncertainty as key challenges. The “prices paid” index climbed to its highest level since 2022, signaling mounting inflation pressure.   Despite the softening backdrop, employment held steady. The hiring index rose marginally in May, following two straight months of decline, suggesting firms are cautious but not yet cutting staff broadly.   The report strengthens the case for the Federal Reserve to keep interest rates on hold, as signs of stagflation—slowing growth paired with elevated prices—become more visible.   Still, the ISM services gauge is based on sentiment rather than hard economic data. The gap between these so-called soft indicators and official output or employment figures remains a critical uncertainty.   That divergence may not last. Whether the data catches up in May, June or beyond, we expect tariffs and their ripple effects to remain a persistent drag on economic activity, hiring, and inflation through the remainder of the year.  

Liquidity in bond markets Super low The bond buyback programs by the FED ECB & BOE have caused significant reductions in secondary liquidity in many government and corporate bonds. For example, 50% of newly issued bonds (qualifying) were purchased by the European Central Bank across sectors during its bond buyback program. Secondary liquidity is therfore low to nonexistant creating huge problems for investors wishing to sell or change holdings. No one will buy or switch many corp bonds anymore and a hold to maturity strategy is all many can employ. Even US treasuries, which are the structural benchmark for all other bonds, have seen bouts of illiquidity, mispricings, curve distortions, individual security price/yield distortions, and all the other hallmarks of illiquid markets. While this article talks a big game about the balance sheet reduction at the fed In reality, across the world, all the Central banks are doing is letting their bond holdings mature, as there is no liquidity to sell these back into the market. Perhaps via new issuance in government bonds, some of these Central banks can reduce the overall holdings, but in many cases the Central Bank action and the Treasury action are separated by charter, therefore not joined up. I guess what I'm pointing out is like of liquidity in bondmarkets creates exaggerated price moves, especially in lower quality Illiquid assets like emerging market or high yield. So anticipate that these markets will be severely punished. And that investors in this area will not have means by which they can reduce risk if bond markets trade badly on the back of rate rises, recession, disinflation, and most problematic stagflation #marketstrategy #bonds #federalreserve #investmentstrategy #traders #highyieldbonds #corporatebonds Investors brace for turbulence as Fed balance sheet shrinks by $1tn - https://on.ft.com/3QACPND via @FT

We are in the middle of a massive financial experiment, and very few are aware of it and its implications. "By shortening its issuance profile to reduce long-term interest rates, the Treasury has delivered economic stimulus equivalent to a one-point cut to the Fed’s policy rate" "Forward guidance in the Treasury’s latest quarterly refunding announcement indicates that this backdoor quantitative easing (QE) will continue" "as much as 70% of new debt raised over the last year came from short-term bills, pushing the total well above 20%", which is the average for the Treasury's maturity profile. Instead of issuing debt at long-term rates and allowing those long term rates to rise via the laws of supply and demand and committing to long-term higher cost of capital, the Treasury is issuing shorter-term securities, thus reducing the US deficit's impact on long term rates. Three questions that come to mind regarding this: 1. What happens when the Treasury resumes a more "normal" allocation across the curve? 2. Could this potentially improve market liquidity in the event of a financial shock or crisis (hiking cycles/yield curve uninversion are usually followed by one). 3. When will this end? If it ends soon, could these be the best commercial financing rates we see for some time? https://lnkd.in/grzeMsj6