Hani Redha

Welcome to the PineBridge Podcast. I'm Hani Redha, Head of Strategy and Research for Global Multi Asset. With me is Anders Faergemann, Head of Global Sovereigns and Economics, and we'll be discussing the global rates and FX update, we've just concluded our strategy meetings for the month, and I've confirmed our soft landing scenario as base case. But Anders, please summarize all the conclusions for us.

Anders Faergemann

Yeah, thanks Hani. There were no major bombshells in our investment meetings, they only arrived after. So this week, in relation to renewed tariff threats on the EU and talk of Trump ousting Powell before his term expires in May next year, and we can come back to those, but in terms of main summary, we reiterated our conclusions from the previous meeting that the Fed has room to resume its rate cutting cycle over the next 12 months, in line with our soft landing scenario, as you highlighted, and really further evidence suggesting peak CPI will be lower than previously feared, and the whole debate about stagflation back in April appears exaggerated as such. We kept our US rates forecast unchanged, so we have three policy cuts priced in for the next 12 months, and with that, a 4% 10 year rate as our forecast. In contrast, we took out one of two remaining ECB cuts and affirmed German bond yield forecast at 2.75% so the main pushback, I'd say, was on whether September FMC is a live meeting and how many cuts we can expect over a more extended period, so 12 to 18 months, so a bit longer than our usual forecasting period, but as a group, we see the Fed ending up doing fewer cuts than the market is pricing. But we need to do some more work on our star, the neutral rate. But with that, I'd say it's in line with our Euro dollar forecast of 115 which we kept unchanged, and we've seen some sort of turnaround, a potential reversal in the dollar more recently, but that could just be a tactical bounce. But Hani, I understand that you and your team have been busy looking at the cyclical factors within the US economy and how to use that knowledge to make better predictions. So can you tell us a bit about how that is influencing your macro and rates views?

Hani Redha

Absolutely so yes, overall, we've seen a lot of resilience in the US economy, but we've been asking ourselves two key questions, are policy rates actually restrictive? Whatever? Then solve that and we see and where are the weakest links? What state are they in? Because this should tell us how much the Fed should cut rates. I think we all agree that Fed should be getting going with a resumption of the cutting cycle. But how much should they be looking at cutting and what we find is that we really need to zero in on cyclical sectors like manufacturing and residential construction. 

So home building, and although these sectors only account for about 20% of GDP, US is services dominated economy, but they actually account for almost all of the cyclicality, and if we're thinking about where we are in the cycle and any evidence of restrictiveness in monetary policy, this is where we need to focus, because these are the sectors that cause the biggest increases in unemployment in a downturn, given the combination of their size, which has diminished over the long term. Also their inherent cyclicality, which has not diminished at all. They remain highly cyclical. And what we see is that growth in these sectors peaked in early 2022 and have been decelerating ever since. And they are soft, but not falling off a cliff. These are again rate sensitive sectors right related to mortgage rates, in home, building and industrial production being rate sensitive as well. 

And so they are in need of Fed cuts to support them. But the sense we get is that these would be adjustment cuts just to stabilize things, rather than emergency cuts taking us really low in Fed funds. And interestingly, the margins of companies in these sectors have fallen, but they remain above average, and margins lead employment decisions, and this may be why we haven't seen any. Significant increase in jobless claims or layoffs, but this is the part of the labor market which makes me a little more nervous. It is a bit more precarious, but we think a few rate cuts should be enough to avoid negative outcomes. So for now, this analysis of cyclicals shows us that under the hood, things are a little less robust than what we see on the surface. Monetary policy is somewhat restrictive. 

The Fed should be cutting once the tariff storm starts to settle, but nothing is screaming emergency, and it confirms our broader view that we've had for some time now that we're in a higher nominal world with higher growth and inflation as baseline, due to expansionary fiscal policy, a vibrant investment environment due to AI technology, spend, green investment, all of these factors imply a Higher terminal rate and potentially shorter cutting cycle now, Anders, everything I've laid out, our current thinking is about what the Fed should do, but of course, there's a lot of focus right now about on the Fed and the changes we may see there, which may affect what the Fed will do. And I know this is a focus area for our research, and we'll have more to say next month, but take us through our thinking at this point and also summarize the key we're making now with regards to rates positioning.

Anders Faergemann

Yeah, thanks Hani. We need to do some more work on FOMC composition, but so far, the sort of two key aspects to the whole debate around Fed independence and how the Fed will look next year, when Paul's term expires. And that has been all the talk about the potential for Trump appointing a Fed shadow chair or ousting Powell too early, but leaving aside the legal implications, I think the two key aspects here, first of all, who will be appointed the next Fed chair? And secondly, what does it mean for the Fed's independence? So reading the tea leaves, Kevin Hassett is now the front runner to replace Powell. He ticks all the boxes as a loyal Trump supporter, and his rhetoric has been overwhelmingly dovish. 

He's also echoed Trump's criticism of the Fed, but I'd say the fact that he's become more of a spokesman, rather than an advisor to the President, could work against him regarding how the market will react to his appointment, but also how he manages to work around a building consensus within the FOMC, and I'll come back to that later. Kevin Warsh has been the front runner up until recently that, I think to his detriment, he's been sort of more hawkish, or considered more of a hawk. But as we know, Trump likes competition, so we may still see these two as front runners. The next step will be when Kugler retires in January, and then for Powell to make a decision on whether to step back from the board when his term as chair expires in May, if we move on to the other issue of Fed independence, and how that keep weighing on the shape of the Treasury curve, and why we saw such a big reaction in the treasury market yesterday and we saw a drop in the dollar. 

It's really about, as I said, central bank independence, the Fed's independence. And so why is that so relevant? Well, I studied economics back in the 1990s and back then, central bank independence was all the rave together with inflation targeting, and it was all about making mum's policy decisions more efficient. So the crux of the issue of having an independent central bank is, if you don't, you'll be introducing a timing consistency policy or problem, because typically that political cycle is shorter than the business cycle, and you end up being misaligned if you have too much political influence on rate setting. 

So in theory, you want the government to set policy goals for the central bank, such as low inflation and high employment, as we know, and leave the central bank to set interest rates accordingly. That should mean that you can achieve lower inflation, better credit rating, and with that, a lower risk premium, in contrast, and this is what we're seeing now. 

I see two issues. One is that if you get a politically appointed Fed chair that will automatically lower the central bank's credibility. But then, as I said earlier, the second point is really that it may create difficulties for a Fed Chair such as Hasid, who may not be viewed as an objective central banker, and so he may face difficulty being. Building consensus, with a lot of the FMC members being academics, technocrats, and having their own reputation to abide. So all of this could lead to increased uncertainty, and with that higher risk premium. 

So Hani, I don't know if it was a trial balloon that we saw, but we did see the market reaction, steeper curve, a weaker dollar. And I'd say that defies the purpose of Trump appointing a shadow Fed chair, or dovish Fed chair, in the sense that you're effectively mitigating the benefits of cutting interest rates if part of the curve is going higher, and so US debt expenses will remain same or not come down as much as would otherwise be. So I don't know if you have any views on that, but maybe just take us through the summary of this and wrap up please.

Hani Redha

Sure thing. Anders, yeah, thanks. I think this is a key area of work that we're doing now, looking at these in terms of scenarios, and maybe how we even define the scenarios for 2026 in terms of the level of independence, or the extent to which we see the Fed deviate from what we think the economy needs, and yeah, anything beyond what it needs in terms of cuts, I think translates into a steeper curve. 

But I recognize at this point in our discussions we were highlighting that the market has Fed funds down to around 3% by the end of next year to eat. That's pretty aggressive. That would be more than what the economy probably needs, and would probably correspond with a steeper curve. So at this point, we're not making that our base case, not assuming that the Fed is going to move that far, but that's going to be the area of focus for us. But thanks Anders, I think that's all very clear and actionable. We haven't really changed our core scenarios. The forecasts have been quite robust in the sense that we haven't been pushed around by the market, and we've seen yields grinding towards our target of 4% on the 10 year. 

But with that, let's end here and we'll be back next month for more information, please visit pinebridge.com. Until next time, thanks for listening. 

ENDS