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Navigating Volatility Amid Federal Reserve Policy Shifts
Dr. Mahnoosh Mirghaemi
August 4, 2024
7 min read
The markets experienced a turbulent week, with a pronounced selloff in stocks and a significant drop in bond yields. This reaction was sparked by a surprisingly weak jobs report on Friday, heightening concerns that the Federal Reserve's decision to keep interest rates at a 20-year high could precipitate a deeper economic downturn. Wall Street voices calling for substantial rate cuts have grown louder, leading to a rally in two-year Treasuries, though this might have been premature.
The two-year yield witnessed its most substantial decline in over seven months, pushing its 14-day relative strength index to 13, a level not seen since 1998 outside the pandemic. This weak employment data prompted major financial institutions like Citigroup and JPMorgan to predict that the Fed might begin its easing cycle with two 50 basis point cuts. The Overnight Index Swap (OIS) market currently reflects a 70% likelihood of such a move in September, with expectations that rates could fall to 3% by the end of 2025.
Federal Reserve Policy Shifts: The Federal Reserve kept interest rates unchanged last week but signaled potential rate cuts starting in September, reflecting increasing concern over the labor market. Chair Jerome Powell acknowledged that while the job of controlling inflation isn't complete, there is room to begin reducing the policy rate. This indicates that labor market data may now play an equally important role as inflation figures in guiding future Fed actions.
Labor Market Dynamics: The employment report for July showed the economy adding 114,000 jobs, significantly below the forecasted 175,000, with the unemployment rate rising to 4.3%. Wage growth slowed to 3.6%, marking the smallest increase in over three years. Despite these figures, the labor market remains relatively strong, as historically, the current unemployment rate is lower than 90% of the time since 1949.
Yield Curve Movements: The yield curve has been inverted for over two years, traditionally signaling restrictive Fed policies. Last week's data strengthened expectations for an aggressive easing cycle, causing bond prices to rise and yields to fall. The two-year yield dropped below 4.0% for the first time since May 2023, and the ten-year yield fell below 3.90%. We expect short-term yields to decline more rapidly than long-term ones, leading to a gradual normalization of the yield curve.
Market Leadership and Sector Rotation: Despite strong earnings reports from major tech firms, high expectations kept their stock prices in check. The tech-heavy Nasdaq entered correction territory, and the broader market saw a shift into more defensive and cyclical sectors. This change suggests a broadening market leadership, underscoring the importance of diversification.
Volatility and Market Sentiment: Volatility increased significantly, with the VIX index, a measure of market volatility, on the rise. Despite concerns about potential delays in Fed rate cuts and seasonal volatility trends, historical data indicates that strong market performance in the first half of the year often leads to positive outcomes in the second half.
Looking ahead, several key factors will shape market movements:
Federal Reserve's Decisions: The upcoming Fed meeting and subsequent statements will be crucial. Market participants will closely monitor any changes in the Fed’s stance on rate cuts, especially given recent labor market data.
Economic Data Releases: Important economic indicators, including the ISM Services report, will provide further insights into the health of the economy and potential Fed actions.
Earnings Reports: The earnings season continues, with updates from various sectors offering clues about the broader economic outlook and sector-specific trends.
European stocks also experienced significant movements last week. The Stoxx Europe 600 index rose by 2.2% in dollar terms in July, outperforming the S&P 500 and Nasdaq 100. This was the largest monthly outperformance compared to the tech-heavy Nasdaq 100 since December 2022. The European market's lower exposure to the tech sector provided some insulation against the tech selloff seen in the US. Sectors such as construction, utilities, banks, and real estate led gains, while technology lagged.
Economic data from Europe indicated resilience, with the euro-area economy growing more than expected in the second quarter, despite a surprise contraction in Germany. However, political instability, particularly in France, and Germany's significant exposure to China pose risks to future performance.
Given the current market conditions, here are some strategic considerations:
Diversification: With market leadership broadening, maintaining a well-diversified portfolio across different sectors is crucial. Defensive sectors that typically perform well during periods of declining bond yields can provide stability.
Bond Investments: Considering the expected rate cuts, now might be a good time to increase exposure to intermediate and long-term bonds. However, be mindful of reinvestment risks associated with cash-heavy portfolios.
Opportunistic Re-balancing: Use market pullbacks as opportunities to re-balance and deploy fresh capital, ensuring alignment with long-term investment goals.
In conclusion, the markets are navigating a complex landscape marked by significant policy shifts, economic data fluctuations, and sector rotations. Staying informed and adaptable is key to navigating these changes effectively. Maintaining a diversified portfolio and being ready to capitalize on market opportunities will be essential strategies for the weeks and months ahead. We use short-term pullbacks as opportunities to re-balance and diversify portfolios.
