Market Commentary | Q3 2024 Halftime Report
Summary
RECORDED 8/22/2024
This Halftime Report begins (like many others…) with a discussion on inflation, highlighting the dual mandate factors of US Consumer Price Index and the US Unemployment Rates. While Core Goods, Food, and Energy Inflation are at bay, Core Services Inflation remains high. The discussion closed with a look into Owners Equivalent Disinflation and a review of recent employment numbers.
Next up Jim discusses the Treasury Yield Curve and the bonds market.
Sam explains the End of the Yen Carry Trade and short term disruption this caused the markets.
Sam finishes the conversation with an update on the polls, which historically have not had significant impacts on the markets.
Transcription
Sam Chaplin:
Hi everybody. Welcome to PFA’s third quarter halftime report. We’re going to be sharing data with you today as of the 22nd of August, update on the economy and the markets. Jump right into it with our founder and chief investment officer, James Bradley.
Jim Bradley:
I just want to make sure that everybody knows, all of the great fans of this particular halftime report who can’t live without us, that Sam is just freshly back from his honeymoon. And so if he’s looking especially relaxed today, it’s not just because the VIX is below 16, it’s because he’s just had some time to get off the grid, which is great.
Sam Chaplin:
It’s all good, it’s all good. Nothing to worry about here. All right, so we will jump into it. I’m going to take a look first at some of the major drivers in the markets. I’d say the two primary drivers this year have been optimism around artificial intelligence and expectations around interest rates. We’re going to focus primarily on the economy and interest rate expectations, which has to do with the Federal Reserve.
The Federal Reserve has two primary responsibilities referred to typically as their dual mandate. One is to keep prices stable, keep inflation running around 2%. And two is to maintain full employment, which is typically somewhere around 3% of unemployment. As we can see here, one of those mandates has become much better closer in line to where it should be while the other has been ticking up into a little bit of a concerning territory. Consumer price index measuring a basket of products over the past year is currently up 2.89% as of the last report, down significantly from the 9% gains we are seeing back in July of 22. So some significant progress there led by higher interest rates, slowing demand. Jim’s going to dive a little further into the inflation story.
On the other side, we’re looking at US unemployment, which stayed lower than people expected for quite some time despite those higher interest rates. But over the past few months has started ticking upwards to 4.3% now. So we’re starting to see concerns shift from the inflation side of the mandate to the unemployment side of the mandate and the market is digesting that.
So without further ado, I’ll pass it over to Jim to talk about inflation.
Jim Bradley:
I’ll take that first half, the inflation half. And when we look at where inflation is, as Sam pointed out, it is coming down and it continues to come down, not only in areas that tend to be a little bit more divergent at any given time, it can come down faster. But the encouraging thing for us, and I think for the Fed is that inflation overall, even in areas that tend to be a little stickier, is still coming down.
One place that we’re looking at inflation still being a little bit elevated relative to where it was, is in services. So this graph that you’re seeing here, if you just focus on the blue portion, you can see that it was kind of bubbling along at a relatively steady rate. Services inflation dropped at the onset of the pandemic, but that, I guess revenge travel, revenge spending as we began to crawl out of the pandemic really drove the price of services up and they haven’t come down nearly as much. But everything else, all the other components that were part of the big blow up in inflation like core goods, the price of lumber and building materials as everybody got out and spent their stimulus, money spiked temporarily, but that inflation is gone and now you can see those dark lines at the end of the graph here are actually lower. So the prices on those have actually started to come down.
And the red, the red is energy and energy can be a little bit more dicey and can be a little bit more volatile when it comes to price movements, but we can see that that over the past year or so has also been kind of ameliorating impact on inflation as well. So as long as we don’t get big spikes in energy, as long as food and goods don’t spike, that kind of trend that you can pick up at the end of the graph here with the blue, the services starting to come back to normal is encouraging. And an idea that interest rates may be set to come down at a Fed funds rate level because partially of the fact that getting closer to mission accomplished on the inflation side.
Going into the next slide, I only touch on this owner’s equivalent rent slide because owner’s equivalent rent kind of is one of those factors that tends to take its time working its way through the process and finding its way into the headline inflation numbers. And so that shows us two things. There was a bit of a spike between about 2001, 2002, but later in 2003 and here in 2004 that owner’s equivalent rent has been disinflating at a pretty fast rate, about as fast as we’ve ever seen historically. So that’s kind of led us to two things.
One, the spike was a big part of why inflate… The market kind of got jostled around a little bit later in 2023 and early on into 2024 because of a slowdown in inflation. I think this had a lot to do with it, and this is an encouraging sign to see that number coming down and could lead to further reductions in the inflation rate that would be helpful when it comes to getting inflation under control. It’s not always a great thing, the impact is mixed. On one hand, homeowners can benefit from lower housing costs and have more disposable income. On the other hand, a decrease in owner’s equivalent inflation could indicate a weakening housing market and slower economic growth. And that’s kind of that dichotomy, that dual mandate that Sam started out by talking about.
Speaking of Sam, I’m going to go from the inflation side of the dual mandate over to employment and turn it back over to him.
Sam Chaplin:
Thank you, Jim. Yeah, to segue a little bit, I would say the first phase of inflation was largely caused by a lot of money being pumped in the economy stimulus post COVID, along with supply chain disruptions, more supply, not enough demand causes inflation. And one of the reasons it stuck around quite some time is this imbalance in the employment market. You might hear the term, employment market for quite some time and that was contributing to inflation. I think this chart does a good job of showing what that means, what a tight labor market means and why it causes inflation. So we’re looking at unemployed persons in the teal versus job openings in the blue. You could see back in 2022 there was nearly two job openings for every unemployed person.
That really did two things. One, it meant unemployed people would find it relatively easy to get a job. And two, people that were employed would find it relatively easy to switch jobs and get paid more money. Both those things mean people are getting paid more, means they’re spending more and that helps put some pressure on prices as well, causing some inflation. And the Fed’s really been… Part of raising rates is to try to get this employment market back in balance where there isn’t such a distortion there. And we’ve seen that happening slowly as the job openings have started to trend towards the amount of unemployed people. So there’s now much better balance of job openings versus unemployed people and we’ll see that on the next chart as well.
We’re looking at prime age employment ratio back to where it was before COVID. So really positive news there. The fact that inflation is returning to about target at about the same time employment has gotten back to full employment here is really positive in sending the right signals to the Fed. And now if they don’t want to lose these gains they’ve made, so the conversation is shifting to when are they going to cut rates? Markets right now after a few upticks in unemployment are thinking that they will start cutting rates as soon as September at 25 basis points in that meeting and potentially another two or three in the meetings afterwards. And then they will sit tight and assess and see how the economy progresses. But that’s been very positive for the markets as we’ll see on the next slide, especially for the bond yield curve, which has come down quite significantly.
Jim Bradley:
So we’ve been alluding to both these things, the dual mandate, the inflation coming down, check, but now unemployment coming up. Those are both opportunities for the Fed to potentially lower rates out of the more restrictive monetary policy levels that they’ve been at. Markets certainly see that and the bond market definitely sees that. And when we look at the difference in the yield, what we call the yield curve where interest rates fall depending upon years to maturity, there’s a pretty sizable shift from where we were in July to where we are mid-August here, and that shift was definitely downward and that shift downward definitely had a lot to do with the market seeing exactly what we’re seeing. Inflation is still coming down and they’re starting to be a little bit of pressure on the economy with the jobs market kind of loosening some of that tightening and getting back to kind of more normal levels.
And this is really, I think we talk about things like a Fed dot plot, we talk about options adjusted spreads, we use all kinds of fancy ways of trying to get at where rates are going to be, but I think that the yield curve is really a great indicator because it’s showing where markets think that yields are going to be down the road in a lot of ways. And so you saw a lot of steepening downward on what we call the shorter end of the curve, the zero to one year part in the gold there drops off really precipitously. And that’s just an indication that I think bond market participants really see a relatively aggressive or at least sustained trend downward in interest rates over the short term, over the next year or two.
But it also declined, the yield curve did over the longer term as well. You see way out to 30 years declined a good bit. And that’s encouraging as well, not only for bond holders who if they were in cash maybe were able to get a high yield savings vehicle of 5%, but if they were in bonds, this decline in the yield curve actually improves bond prices, which enhances it and they might’ve gotten closer to 10% over that period of time. So another good reason not to necessarily forward in cash when interest rates are higher, still take some what we call duration risk in a portfolio. But also good news for home buyers who are now seeing mortgage rates fall to their lowest level in about, I think around a year and a half or so with the thirty-year mortgage on average somewhere in about the five point… No, I’m sorry, the 5.62% range. That’s actually on a fifteen-year mortgage, I’m misquoting that, but the thirty-year mortgage at about a 6.46% range, still a good bit lower than it was 15 months ago.
So that’s encouraging in a lot of ways and hopefully encouraging in a way that we’re seeing the Fed being able to loosen up without necessarily being faced with an imminent substantial decline in the market. Instead of a slump, we’re talking more about maybe a bit of a slowing here.
Still, we saw some pretty significant volatility a couple weeks back in the earlier part of August and despite what we’re otherwise seeing as good news here and why did that happen, I think Sam’s going to give us a little bit of an indicator as to what the story was behind that.
Sam Chaplin:
Yeah, we always like to touch on any major headlines that have come across over the last quarter and one of the big ones this quarter was the end of the yen carry trade. Sounds pretty scary. I’ll do my best to explain how this works here. The carry trade is when you borrow currency from a low interest rate country and then redeploy that into bonds in a higher interest rate country. In this case people borrowing yen, which has for the last couple decades been low interest rates and pretty steady currency, redeploying that into other countries. Maybe you go to the US, borrowed at 1% and then you lend it 4%. Now you make that 3% spread, right? Sounds like free money, but as one of my favorite finance professors would say, “There’s no free lunch in finance.” And the reason there’s no free lunch in this one is because you are assuming currency risk. So eventually you’re going to want to get those yens back to dollars and by doing so, you’re going to have to use whatever the prevailing exchange rate is.
So if yen strengthens against the dollar during this trade, that will erode your gains. Say you had a 3% spread that you were hoping to make, well if the yen goes up 3%, now you haven’t made any money because when you turn it back to dollars you’re back where you started. The problem was this year the yen was up about 14% at one point. So a lot of the people that had been doing that trade, which has been profitable for quite some time, got caught up that they were now losing money on it. It wasn’t as safe as it used to be. They had to close out their positions.
They do that by selling stocks and that caused this correlation in the markets. You can see in the chart where for some reason, and this is the reason, that the chart of the yen versus US dollar exchange rate and the chart of the NASDAQ were pretty highly correlated there for a while. It’s really difficult to tell how much money is caught up in this trade, estimates are anywhere from one to 7 trillion. But I think what’s important to note here, and you can see the market shaking it off more recently, is that that doesn’t necessarily mean that money’s leaving the markets for good. It’s likely going to find another area, another carry trade for different countries to re-enter into the market. So this is something you see as more of a short-term distortion in markets than it is a long-term concern. So that is the explainer on the yen carry trade.
The other thing that-
Jim Bradley:
A [inaudible 00:15:33] said, a trillion here, a trillion there, before long you’re starting to talk about real money.
Sam Chaplin:
Yep. Next up we got the polls. As everybody’s probably aware, Joe Biden dropped out of the race as of July 21st, and since then the polls have changed pretty significantly with Kamala Harris taking the lead over Donald Trump. We don’t like to say that politics has a huge influence on markets and I think we can see some evidence of that where a shift this dramatic over a short period of time actually didn’t have much influence on markets. One thing I will say is that one of the few things these two politicians have in common is that they’re pretty light on policy specifics. They really harp on social issues and rhetoric and whatnot, and not a whole lot going on out there that you could say this is exactly what they’ll do when they’re president and that’s what the markets want to see.
So again, the markets largely shook this off and hopefully this is the last time we’ll have to talk about it because next time we meet all things going well, we will know who our next president is going to be. So as always, we recommend not to get caught up in the politics of it. It’s hard enough to predict the economy and know how markets are going to react to it without looking through a divisive political lens. So as always, we follow the fundamentals and not the behavioral aspects. And that is our last slide for today, under 20 minutes. We did all right. Hope you enjoyed it, and will join us again next quarter.
Jim Bradley:
We look forward to seeing you in November. Thanks.
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