With the May FOMC meeting in progress, our analysts Matt Hornbach
and Michael Gapen offer perspective on U.S. economic projections
and whether markets are aligned.
Read more insights from Morgan Stanley.
----- Transcript -----
Matthew Hornbach: Welcome to Thoughts on
the Market. I'm Matthew Hornbach, Global Head of Macro Strategy.
Michael Gapen: And I'm Michael Gapen,
Morgan Stanley's Chief U.S. Economist.
Matthew Hornbach: Today we're talking about
the Federal Open Market Committee Meeting underway, and the path
for rates from here.
It's Tuesday, May 6th at 10am in New York.
Mike, before we talk about your expectations for the FOMC meeting
itself, I wanted to get your take on the U.S. economy heading
into the meeting. How are you seeing things today? And in
particular, how do you think what happened on April 2nd,
so-called Liberation Day, affects the outlook?
Michael Gapen: Yeah, I think right now,
Matt, I would say the economy's still on relatively solid
footing, and by that I mean the economy had been moderating. Yes,
the first quarter GDP print was negative. But that was mainly
because firms were frontloading a lot of inventories through
imports. So imports were up over 40 percent at an
annualized pace in the quarter. A lot of that went into
inventories and into business spending. That was just a
mechanical drag on activity.
And the April employment report, I think, showed the
same thing. We're now averaging about 145,000 jobs per month
this year. That's down from about 170,000 per month in the second
half of last year. So the hiring rate is slowing down, but no
signs of a sudden stop. No signs in layoffs picking up. So
I'd say the economy is on fairly solid footing, and the
labor market is also on fairly solid footing – as
we enter the period now when we think tariffs will have a greater
effect on the outlook.
So you asked, you know, Liberation Day. How does that
affect the outlook? Right now we'd say it puts a lot of
uncertainty in front of us. on pretty solid footing now. But
Matt, looking forward, we have a lot of concerns about where
things may go and we expect activity to slow and inflation to
rise.
Matthew Hornbach: That's great
background, Mike, for what I want to ask you about next, which is
of course the FOMC meeting this week. We won't get a new set of
economic projections from the committee. But if we did, what do
you think they would do with them and how would you assess the
reaction function one might be able to tease out of those
economic projections?
Michael Gapen: You're right, we don't get a
new set of projections, but New York Fed President John
Williams did provide some indication about how he adjusted his
forecast, and John tends to be one of the – kind of a
median participant.
He tends to be centrist in his thinking and his projection. So I
do think that that gives us an indication of what
the Fed is thinking; and he said he expects GDP growth
to slow to somewhat below 1 percent in 2025. He expects
inflation to rise to 3.5 to 4 percent this
year, and he said the unemployment rates likely to move
between 4.5 and 5 percent over the next year.
And those phrases are really key. That's the same thing, Matt, as
you know, we are expecting for the U.S. economy and I do think
the Fed is thinking of it the same way.
Matthew Hornbach: So one final question for
you, Mike. In terms of this meeting itself, what are you
expecting the Fed to deliver this week? And what are the risks
you see being around that expectation; you know, that
might catch investors off guard?
Michael Gapen:
I think the Fed's main message this week will be that they're
prepared to wait, that they think policy's in a good spot right
now. They think inflation will be rising sharply, that the tariff
shock is a lot larger than they had anticipated earlier this
year. And they will need time to assess whether that inflation
impulse is transitory, or whether it creates more persistent
inflation. So I think what they will say is we're in a good
position to wait and we need clarity on the outlook before we can
act.
In this case, we think acting means doing nothing. But acting
could also mean cutting if the labor market weakens. So I think
there'll be worried about inflation today, a weak labor
market tomorrow. And so I think risks around this meeting really
are tilted in the direction of a more hawkish
message than markets are expecting at least vis-a-vis
current pricing. I think the market wants to hear the Fed will be
ready to support the economy. Of course, we think they will, but
I think the Fed's also going to be worried about
inflation pressures in the near term. So that, I think,
might catch investors off guard.
So Matt, what I think might catch investors off guard may be a
little misplaced. I'm an economist after all. You're the
strategist, you're the expert on the treasury market and how
investors may be perceiving events at the moment. So the treasury
market had quite the month since April 2nd. For a moment U.S.
treasuries didn't act like the safe haven asset many have
come to expect. What do you think happened?
Matthew Hornbach: So, Mike, you're
absolutely right. Treasury yields initially fell, but then spent
a healthy portion of the last month rising
and investors were caught off guard by what they saw
happening in the treasury market. I've seen this type
of behavior in the treasury market, which I've been watching now
for 25 years. I've seen this happen twice before in my
career. The first time was during
the Great Financial Crisis, and the second time I
saw it was in March of 2020. So, this being the third time you
know, I don't know if it was the charm or if it
was something else, but treasury yields went up quite a
bit.
I think what investors were witnessing in the treasury
market is really a reflection of the degree of uncertainty and
the breadth with which that uncertainty, traversed the world.
Both the Great Financial Crisis and the initial
stage of the pandemic in March of 2020 were events that were
global in nature. They were in many ways systemic in nature, and
they were events that most investors hadn't contemplated or seen
in their lifetimes. And when this happens, I think investors tend
to reduce risk in all of its forms until the dust settles. And
one of those very important forms of risk in the fixed income
markets is duration risk.
So, I think investors were paring back duration risk, which
helped the U.S. Treasury market perform pretty poorly at one
moment over the past month.
Michael Gapen: So Matt, one aspect of
market pricing that stands out to me is how rates markets are
pricing 75 basis points of rate cuts this year. And just
after April 2nd, the market had priced in
about 100 basis points of cuts.
How are you thinking about the market pricing today? Matt,
as you know, it differs quite a bit from what we think
will happen.
Matthew Hornbach: Yeah. This is where,
you know, understanding that market prices in the interest rate
complex reflect the average outcome of a wide variety
of scenarios; really every scenario that is conceivable in
the minds of investors. And, of course, as you mentioned, Mike
depending on exactly how this year ends up playing out there,
there could be a scenario in which the Federal Reserve has to
lower rates much more aggressively than perhaps even markets are
pricing today.
So, the market being an average of a wide variety of outcome will
find it really challenging to take out all of the
rate cuts that are priced in today. Or said differently, the
market will find it challenging to price in your baseline
scenario. And ultimately, I think the way in which the market
ends up truing up to your projections, Mike, is just with time.
I think as we make our way through this year and the
economic data come in, in-line with your baseline projections,
the market will eventually price out those rate cuts that you see
in there today. But that's going to take time. It's going to take
investors growing increasingly comfortable that we can avoid a
recession at least in perception this year before, you know,
on your projections, we have a bit of a slower economy
in 2026.
Michael Gapen: Well, it definitely does
feel like a bimodal world, where investor conviction is low.
Matt, where do you have conviction in the rates market today?
Matthew Hornbach: So, the way we've been
thinking about this environment where we can avoid a recession
this year, but maybe 2026 the risks rise a bit more. We
think that that's the type of environment where the yield curve
in the United States can steepen, and what that means practically
is that yields on longer maturity bonds will go up relative to
yields on shorter maturity bonds. So, you get this steepening of
the yield curve. And that is where we have the highest
conviction; in terms of, what happens with the Treasury market
this year is we have a steeper yield curve by the time we get to
December.
Now part of that steepening we think comes because as we approach
2026 where Mike, you have the Fed beginning to lower rates
in your baseline, the market will have to increasingly price with
more conviction a lower policy rate from the Fed. But then at the
same time, you know, we probably will have an environment where
treasury supply will have to increase.
As a result of the fiscal policies that the government
is discussing at the moment. And so you have this
environment where yields on longer maturity securities are
pressured higher relative to yields on shorter maturity
treasuries.
So, with that, Mike, we'll wrap our conversation. Thanks so
much for taking the time to talk.
Michael Gapen: It's been great speaking
with you, Matt.
Matthew Hornbach: And thanks for
listening. If you enjoy Thoughts on the Market, please
leave us a review wherever you listen and share the podcast with
a friend or colleague today.
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