BearBull Group Research: The Fed Considers Key Interest Rates at 3.25% by 2025
BearBull Global Investments Group (DIFC)
BearBull Global Investments Group is a leading independent Swiss wealth advisory firm based in the DIFC
Key Points:
GDP growth remains strong
The release of the U.S. GDP for the second quarter suggested another particularly solid quarter, largely supported by a rebound in household consumption. The published growth rate of +3% annualized reflects a significant recovery compared to the first quarter of 2024, which was mainly driven by investments in equipment and personal consumption, although the latter was weaker than at the end of 2023. A similar momentum is observed as in the fourth quarter, which recorded an increase of +3.4% at that time. By the end of June, consumption proved strong, rising by +2.8%.
In terms of contributions to the +3% GDP increase, consumption contributed +1.9% and changes related to inventories contributed +1.05%. Fixed investment spending (+0.42%) and government spending (+0.52%) also had positive contributions. Only net exports (-0.9%) pulled GDP down. The U.S. economy continues on a relatively solid growth path leading into the summer, in an environment less marked by inflationary risks, though with a core personal consumption expenditure (PCE) component still rising by +2.8% and a price index of +2.5% at the end of June.
As the third quarter of 2024 comes to a close, growth estimates for the period ending are still quite robust. According to the latest Bloomberg survey of 75 economists, GDP is expected to have progressed by +2%, significantly lower, however, than the Fed's Atlanta flash GDP measured by the GDPNow index, which is again above +3%.
In this context, at the end of September, the Federal Reserve finally initiated a new cycle of easing rates with a relatively unexpected decrease of -0.5%, as the majority of observers were anticipating a -0.25% cut in the key rate. After estimating at the end of 2023 that there would be up to six rate cuts in 2024, investors had largely revised their expectations and were patiently awaiting a reversal of the monetary policy cycle. Economic statistics from the labor market remained solid until mid-quarter, pushing back the timeline for this change in positioning. However, the sharp decline in job creation in August to its lowest recent level (99,000) certainly triggered the central bank's decision. A slightly lower level of personal income for households, slowing consumption, and stagnation in durable goods orders are just a few examples of new trends suggesting a slowdown is underway for the third quarter. Nevertheless, the overall picture of the health of the U.S. economy remains difficult to grasp, as other factors continue to point to robust dynamics.
Quarterly GDP growth — United States
Will the second half of the year be weaker?
The Federal Reserve finally decided to lower its key rates, signaling a shift in monetary policy as inflation and employment data allowed for this move. Despite the cut, economic forecasts remain optimistic, supported by central bank indicators like GDPNow. While some employment data shows a potential slowdown, other statistics, such as unemployment claims at their lowest (NSA) and cumulative claims decreasing since July, suggest the labor market may not be weakening as much as expected. Some figures challenge the narrative of a broader economic slowdown.
The same applies to the real estate market, which has yet to benefit from concrete short-term funding rate cuts. However, new housing starts rose significantly by +9.6% in August, and building permits increased by +4.9% by the end of the quarter. This contrasts with a decline in new home sales, which fell from +10.6% in July to -4.7% in August.
Real personal consumption slipped from +0.4% in July to +0.1% in August, while household spending showed a similar deceleration from +0.5% to +0.2%, indicating a continued slowdown. Consumer confidence was likely affected by high financing costs amidst significant household debt. The Conference Board's confidence index fell from 105.6 in July to 98.7 in August, reflecting these concerns before the Fed's rate cut decision.
Since 2022, consumer credit growth has followed a clear downward trend, showing no signs of reversal. After rising by $42 billion in June 2022, a significant contraction occurred over two years. However, the latest statistic from July 2024 shows a substantial rebound, with a 500% increase in revised amounts from $5.22 billion to $25.15 billion in June, marking the strongest growth since November 2022. Credit balances, including credit cards, rose by $10.6 billion, and non-revolving credit jumped by $14.8 billion year-over-year, contributing to strong retail sales growth. However, this factor is unlikely to support short-term consumption.
US recessions, Long rates and Fed funds
Leading indicators for services remain positive
Leading indicators still point to a delicate situation in the manufacturing sector and much better prospects on the services side. Regarding the ISM indicators, the latest statistics concerning services showed an improvement, with a significant rebound from the lows of June (48.8) to a more encouraging level of 51.5 at the end of August. However, the manufacturing ISM remains below the growth threshold at 47.2, indicating likely weakness in the industrial segment. The ISM for new orders has also declined (46.1), as has the employment index (43.9).
As for other leading indicators, the S&P Global manufacturing PMI has not recovered and remains significantly below 50 in September. Between the more optimistic level observed in February (51.9) and that of September (47.3), the trend has clearly asserted itself. Industrial production has proven to be extremely volatile during this period, recording a drop of -1% in July and a rebound of +0.8% in August, but without any real growth. On the services side, the trend remains decidedly positive with a PMI of 55.4 in September.
PMI — ISM indicators
Job market tensions ease
Leading ISM indicators for employment are declining, indicating a reduction in labor market tensions. A significant contributor to this trend has been the decline in job creation, which reached a historic low of fewer than 100,000 new jobs in August, the lowest level since 2021. This drop was particularly evident in the services sector.
Unemployment rate, Income, Labor costs, Salaries
Unemployment claims have temporarily decreased but are now approaching 230,000 filings. Job openings (JOLTS) stand at 8.04 million, significantly below their peak of 12 million in March 2022 and also below the recent average of 9 million, indicating a downward trend. Overall, the labor market, which has been a concern for the Federal Reserve, appears to be normalizing, with the unemployment rate at 4.2%, showing an upward trajectory since January 2023.
The Federal Reserve corrects June inaction
The U.S. central bank has finally considered that the time has come to lower its key interest rates and initiate a pivot in its policy in September, after some ultimately better statistics both on the inflation front and from the labor market. After having excessively feared that the American economy would not react to the rate hikes and the tightening of monetary conditions mainly implemented in 2022 and during the first half of 2023, it now seems ready to consider that it could have already lowered its key rates for the first time at its June meeting. By lowering its rates by 50 basis points, it decides to erase its last two increases from May and July 2023, but it implicitly acknowledges that it might have already acted in June with a first reduction of 25 basis points.
The monetary easing cycle is now underway, and the median projection of the FOMC Dots for the end of 2025 has consequently been lowered to 3.375. This target suggests about six rate cuts over the next fifteen months. However, on the side of Fed Funds, the implied rate for the end of December 2024 of 4.32% has already been lowered to 3.25% for the end of June 2025. With no major surprises and maintaining a scenario of moderate slowing of American growth still above +2% annualized over the next three quarters, we estimate that the market is already anticipating six rate cuts before June 2025.
The US central bank has therefore set a new course for rate cuts in 2025, targeting an estimated range between 3.25% and 3.5%. The Fed chair had already emphasized a few months ago that he was ready to loosen the reins of his policy if inflation parameters allowed it and if the labor market showed signs of slowing down, which is now the case. He also mentioned that he would not wait to see inflation fall below his technical target of +2% before implementing the expected easing. This is also the case, as inflation is indeed slipping but has not yet reached the +2% threshold.
Fed funds, Key rates and USD trade-weighted)
Today, inflation has indeed fallen to +2.5% and +3.2% for the index excluding food and energy, which remains far from its formal target. We estimate that the Federal Reserve will lower its key interest rates again by a standard increment of 0.25% on November 7, following the American presidential elections.
Inflation expected to fall below 2% by Q1 2025
The monthly inflation for August (+0.2%) turned out to be the same as in July (+0.2%), with a services component slightly increasing again after three months, but with a positive impact from the energy segment. Over the past four months, inflation has remained quite stable, recording an average increase of 0.075% per month. The year-over-year CPI has thus fallen to +2.5%, with the services component remaining the only real contributor and driver of price increases at +2.9%. In this context of expected economic slowdown, the Federal Reserve's preferred indicator, the core PCE index, continued its decline in August, dropping to +2.7% year-over-year, while the overall PCE index also fell to +2.2%, both approaching the central bank's +2% target more closely. Finally, producer prices are also back under control (+1.7%), while the index excluding food and energy stands at +2.4%. It seems reasonable, in the context of relatively controlled raw material prices and moderate economic growth, to anticipate a continued decline in inflation (overall PCE) below +2% by the first quarter of 2025.
CPI, PPI & PCE Index
Attractive prospects for USD bonds
The latest GDP growth figures still show no real signs of economic contraction, but if the leading indicators and statistics published during the summer confirm the beginning of a slowdown, the conditions for a continuation of the recent trend of declining yield curves should persist. The favorable evolution of inflation supports both a sustainable momentum for interest rate cuts and the anticipation of adjustments in the yield curves to the new inflation conditions. Over the past four months and four successive announcements of monthly inflation close to zero, long-term rates have reacted particularly well to the change in risk perception. Still above 4.6% at the end of May, long-term rates quickly took another path, entering a new phase of yield decline, reaching 3.6% observed in mid-September.
When inflation seemed to rebound at the beginning of the year, causing new uncertainties in financial markets, we noted that these elements would only be temporary before a more sustainable trend re-emerged, also supported by a reduction in tensions in the services sector. As long-term rates unjustly returned to a level above 4.5%, we reminded that in a context of easing inflationary risks and moderate growth for the American economy, the likely theoretical level for long-term rates should not be that high. Our outlook for the coming quarters clearly indicated a bearish view on ten-year rates that could bring them back down to around 3.5%. We still believe this path remains valid in the short term and anticipate a decrease now to 3.25% for these ten-year Treasury rates during the first half of 2025. In this context of a simple slowdown, we estimate that the key rates (5.5%) should be lowered to 3.5% by the second quarter of 2025 and could drop below 3% if inflation continues its current slide towards the Fed's target of 2%. In a context of gradual flattening of the yield curve, the level of ten-year rates still offers potential for a decline of 75 to 100 basis points and represents an attractive investment opportunity, offering interesting returns and a potential capital gain of +10%.
US Treasury Yields and BBB Bonds (Spread)
A theoretically unfavorable policy for the USD
The correlation of the trade-weighted dollar with the evolution of long-term rates should act as a negative factor for the greenback in the context of economic slowdown and expected rate cuts. However, the Fed's rate cuts have not had a real impact to date. The rate-cutting cycles initiated by other central banks should, in fact, have similar effects on the rates of other currencies, resulting in a maintenance of yield differentials. The convergence of monetary policy changes in Europe and the United States, along with a simultaneous decline in inflation, will likely reduce currency volatility. Yield spreads would remain relatively stable among major currencies, while inflation differentials are more likely to narrow. In this context, the growth differential could be sufficient to strengthen investor interest in American investment opportunities and assets. However, it will certainly be the prospects for capital gains in American bonds and stocks that will support strong demand for dollars. A general appreciation of the dollar thus still seems probable, particularly against the Swiss franc, partly weakened by the SNB in its new phase of monetary policy.
Overall positive outlook for equities
Our positive expectations at the beginning of the year for the evolution of stocks seem reinforced by the Fed's initial implementation of an accommodative monetary policy that favors liquidity. The rate-cutting cycle that is beginning is a positive factor, but it should not be forgotten that the markets have certainly anticipated this change to a large extent, as evidenced by the +20% rise of the S&P 500 (YTD). In the absence of a recession, the current environment should remain favorable for stocks. However, the valuations of American stocks for 2025 at 20.7 times expected earnings may already seem high and could deter some investors. Nonetheless, we believe that the upside potential for American stocks remains significant and maintains a positive recommendation on the asset class.
S&P500 Equities & PE ratio