Summer Closes With Economic Optimism

Treasury yields reached 15-year highs across much of the yield curve in August, with multiple factors contributing to the move. Overall, the economic data trends have surpassed expectations for more than three months and fueled the narrative the Fed might indeed need to keep short-term rates higher for longer, potentially leading to a higher long-run neutral policy rate.

A common measure of this neutral, or natural, rate of interest in economic circles is r-star (r*), a term that has emerged in discussions more in the past month than it has in more than a decade. Loosely defined, r* is the inflation-adjusted rate of interest that supports economic expansion at a target level of inflation. This metric is notoriously difficult to quantify in real time, but market participants’ general focus is whether this estimated rate is higher or lower than what is being priced into the term structure of interest rates at any given time. For example, market speculation that this figure will be higher in the future should lead to higher long-term benchmark yields, which are effectively forward expectations for short-term rates plus a term premium paid for greater interest rate risk.

Also pressuring intermediate and long-end yields in August was the Department of Treasury’s quarterly refunding announcement on July 31 that showed much higher funding needs for the government in the third quarter and potentially beyond given rising budget deficits and other factors (discussed in the Current Market Themes portion of the August Monthly Market Update).

The difference between forward market pricing and Fed guidance has narrowed notably in recent weeks. Based on the June FOMC Summary of Economic Projections (SEP), the median fed funds forecast revealed a 5.625% terminal rate in 2023 and 100 basis points of rate cuts in 2024. In mid/late July, markets were pricing for no more rate hikes in 2023 and 150 basis points of cuts in 2024, but as September begins, the market is more aligned with the Fed. In Jerome Powell’s annual Jackson Hole speech on Aug. 25, the chair of the Federal Reserve offered no material revelations on policymakers’ current perspective other than a firm commitment to return inflation to the 2% target rate. To get there, Powell said he and his colleagues still believe a period of below-trend economic growth, including a cooling of labor market conditions, will be necessary.

Even after considerable policy tightening and a mini crisis in the banking sector, the U.S. economy has remained resilient and in expansionary territory, albeit at a moderating pace. In the final week of August, the July JOLTS report revealed a significant drop in job openings to the lowest level since March 2021, and later that week, the headline unemployment rate rose 30 basis points to 3.8%. However, the latter was attributable to a large increase in the official labor force as opposed to a decline in household employment. Growth in non-farm payrolls exceeded expectations, and wage growth was in line with expectations.

Visit ALM First to read about the latest economic data and overall market trends in the September 2023 Market Commentary.

Jason Haley joined ALM First in 2008 and is the firm’s chief investment officer. He heads ALM First’s Investment Management Group (IMG), which is responsible for leading the investment process and investment theme development. Haley also oversees all capital markets activities, including portfolio management, trading, market research and commentary, and execution of hedging and funding strategies for the firm’s depository clients. He holds an MBA with a concentration in finance and a BBA with a concentration in marketing, both from The University of Mississippi.