CIO still believes the Fed is most likely closer to the end of its tightening cycle than the European Central Bank, contributing to their preference for the euro over the US dollar. (ddp)

On Thursday, the S&P 500 fell 1.4% after weekly data on jobless claims pointed to continued strength in the labor market, with a drop in the number of Americans claiming unemployment benefits for the first time. That followed a 1.1% rally on Wednesday following the release of an S&P Global purchasing managers’ survey that was consistent with slowing activity in August, raising hopes that the Fed could be done hiking.

The outsized impact of such relatively minor releases reflects the fact that the central bank faces a finely balanced decision on its next step. But we expect greater clarity over the coming weeks as investors digest more prominent data releases, along with the Fed’s response, starting with Chair Jerome Powell’s annual speech at the Jackson Hole symposium today:

We believe investors will be looking for long-term rate guidance on rates, as well as on the outlook for the end of the current hiking cycle. Markets have recently moved to price in a higher fed funds rate in five years, a proxy for the long-term neutral level at which rates neither stimulate nor suppress growth. This shift in investor expectations to a higher long-term neutral rate is implicitly an expectation that nominal GDP growth will be sustainably higher than it was during the past 15 years. We believe investors will be on the alert for guidance on the Fed’s view of this neutral level—the theoretical R-star—which could point to higher rates over the long term.

Regarding near-term guidance, Powell looks likely to stick to the recent message that further rate rises will hinge on upcoming data releases, with such decisions likely to be finely balanced as inflation falls, but growth remains resilient. Recent comments by Powell’s fellow policymakers have been mixed. Philadelphia Fed President Patrick Harker said on Thursday that he thought the Fed had “probably done enough,” and that “I’m in the camp of, let the restrictive stance work for a while, let’s just let this play out for a while, and that should bring inflation down.” By contrast, Boston Fed President Susan Collins said the Fed “may need additional increments, and we may be very near a place where we can hold for a substantial amount of time.”

Upcoming labor market data should help set the tone for markets. Top Fed officials have continually stressed that they will need to see a cooling of the labor market to be more confident that inflation will head sustainably back to their 2% target. The release of the August employment data next Friday will be the last such reading before the Fed’s next policy meeting on 20 September. The July employment data pointed to some slowing in the pace of job growth. But unemployment remains close to multi-decade lows. Economists are expecting a similar reading from the August data, with jobs growth of around 190,000—well above the level needed to absorb new workers entering the labor market. If unemployment remains steady at 3.5%, as the consensus would suggest, this would not provide a clear signal of cooling demand for workers either.

The Fed’s favorite measure of inflation looks likely to provide further evidence that inflation is moderating. The core Personal Consumption Expenditure index, excluding food and energy, comes out on 31 August, with economists looking for a month-over-month rise of 0.2% in July. That would be consistent with inflation falling back to the Fed’s 2% target over time, even though the current annual core rate is expected to be 4.1%. This comes ahead of the release on 13 September of the Consumer Price Index for August, which will be the last major data point before the Fed decision.

So, while our base case is that the Fed has already reached the end of its tightening cycle, views on the Fed could continue to shift in response to data over coming weeks. We still believe the Fed is most likely closer to the end of its tightening cycle than the European Central Bank, contributing to our preference for the euro over the US dollar. Meanwhile, with the overall resilience of economic data adding to our confidence that the US is headed for a “softish” landing, we now see a more balanced risk-return outlook for stocks, and we recently upgraded the asset class from least preferred to neutral.

Main contributors - Solita Marcelli, Mark Haefele, Brian Rose, Chris Ptak, Vincent Heaney, Jon Gordon

Original report - Investors shift back and forth on Fed, 25 August 2023.