After the Federal Reserve began a new round of easing last month, the future policy path has not become clear. With the stable performance of economic data, the Federal Reserve is becoming more cautious about the direction of interest rates internally. However, data dependence may also exacerbate the potential market pricing risk of indicator drift, leading to disturbances in risk assets.
At the same time, with the US federal government's fiscal deficit reaching $1.8 trillion this fiscal year, there is undoubtedly more uncertainty about the direction of interest rates.
Kansas City Fed: Interest rate uncertainty at high levels
Recently, the Kansas City Federal Reserve launched a new indicator KC PRU to quantify future interest rate space in response to uncertainty in federal funds policy rates, using market option prices.
According to KC PRU data, the market is currently pricing the possible outcome of the next year's federal funds rate within a range of 1.25 percentage points. Compared to recent decades, especially without considering crisis periods, market divergence is at a high level. In contrast, the average value from 2012 to 2020 was only 0.49%.
The current uncertainty in interest rates reflects different interpretations of economic data by various parties. On the one hand, by historical standards, the unemployment rate remains low, inflation has slowed significantly, and the gross domestic product is growing at a healthy rate. On the other hand, the labor market is slowly weakening, inflation remains above the Federal Reserve's target, and there are significant potential shocks that could disrupt economic expansion. The development of these trends will have an impact on the Federal Reserve's policies.
The leading indicator of the consulting firm announced on Monday fell by 0.5%, accelerating compared to last month. Justyna Zabinska La Monica, Senior Manager of Business Cycle Indicators at the Chamber of Commerce, stated that weak factory orders and consumer prospects in the coming months have dragged down the index's decline. She said, "Overall, indicators continue to indicate uncertainty in future economic activity
From recent statements, there has been an important consensus within the Federal Reserve to cautiously reduce interest rates in the future. Federal Reserve Governor Waller believes that recent economic data, including hotter than expected consumer inflation reports and strong employment reports, indicate that the economy may not slow down as expected, and the pace of interest rate cuts should be more cautious than needed at the September meeting.
However, restrictive monetary policy remains a pressure that will constrain the economy in the future. Boris Schlossberg, macro strategist at asset management firm BK Asset Management, said in an interview with First Financial that in fact, the Federal Reserve faced significant differences in the magnitude of interest rate cuts when it made its decision in September. The economic situation facing policy makers is still complex, with not only short-term challenges to the labor market from hurricanes and strikes, but also the impact of geopolitical factors.
Schroeder believes that the US economy may gradually approach a delicate tipping point, where too fast easing could lead to a resurgence of inflation, while insufficient policy efforts will threaten a soft landing. From historical results, the Federal Reserve has indeed remained vigilant in policy decisions and responded to risks in a timely manner.
Will the federal deficit become a potential risk
The data released last week showed that the US fiscal deficit for the 2024 fiscal year exceeded $1.8 trillion, the third highest level in history.
The US Treasury Department reported that spending increased by 10% this fiscal year, reaching $6.7 trillion, while government revenue increased by 11%, reaching $4.9 trillion. It is worth mentioning that the expenditure on paying net interest on public debt increased by 34%, reaching a record high of $882 billion, which is directly related to the interest rate levels at the end of the Federal Reserve's tightening cycle.
According to an analysis released this month by the Committee for a Responsible Federal Budget, both Democratic presidential candidate Harris and Republican candidate former President Trump's tax and spending plans may further increase the deficit.
Jason Pride, Head of Investment Strategy and Research at Glenmede, and Michael Reynolds, Vice President of Investment Strategy, have stated that on the surface, the policy proposals already put forward by Harris and Trump "add up to significantly widen the federal deficit. Regardless of the election structure, the new government may consider increasing deficit spending by $3.1 trillion to $3.8 trillion over the next 10 years.
On Monday, US Treasury yields rose in a new round of selling, with 10-year bonds approaching their highest level since July and policy sensitive 2-year bonds breaking through 4%. Emily Roland, co chief investment strategist of John Hancock investment management, an investment institution, believes that although the signs that the US economy has remained healthy since mid September have contributed to the rise in treasury bond bond yields, the trend of the bond market seems to partly reflect the prospect of rising government deficits. Evidence in this regard can be found in the increase in the long-term premium of 10-year treasury bond, or the additional compensation required by investors for the risk of holding long-term treasury bond.
It is worth mentioning that a new round of debt negotiations will begin after the US election. The market generally believes that although the possibility of substantial default is unlikely, the test of market confidence is certain. From the recent trend of gold, the continuous intervention of central banks in various countries is also one of the reasons for asset allocation hedging.