The Fed is Getting Ready to Move… Are You?

INTRO: Helping community bankers grow themselves, their team and their profits. This is the Community Bank Podcast.

CALEB: Well, hey, everybody. Welcome back to the Community Bank Podcast. Thanks for joining the conversation today. I’m Caleb Stevens with SouthState Bank’s Correspondent Division, and back on the show is Mr. Tom Fitzgerald here in studio with us. Tom, how you doing?

TOM: I’m doing pretty good, Caleb. And yeah, it’s been, I think the first time I’m actually recording in our quote-un-quote studio, so it’s quite impressive.

CALEB: Yeah, it’s an audio only show, but we’ve thought for a long time about adding a video component to it because we do have a nice studio here with the SouthState sign and some lights and whatnot. Maybe at some point we’ll have the bandwidth to have a video, you know, element to this show. But Tom, you’ve been busy, I’m sure, the past week or so with the bond rally that we had last week. Catch us up on your world.

TOM: Well, yeah, we like we say in the podcast, we actually wanted to record this last week, but the market volatility coming off the jobs report. And then and just the equity sell off that happened across the globe, it really kind of, it was unsettled that you know I guess is the best word you could say. So ,we said let’s kind of let the dust settle a bit, and then come back to it this week. And so, we have seen more calm in the market, some of the worst-case scenarios of like emergency rate cuts between meetings—that’s kind of died down. So, we’re sort of back—I don’t want to say business as usual, but we’re sort of back in that scenario of, you know is the, you know, Fed going to be able to pull off a soft landing. And you know, there certainly seems to be getting, they seem to be getting inflation moving in the right direction. It’s just, you know, is the labor market and economy going to hold up, you know, until they get to that 2% target?

CALEB: Well, one of the things that you put out to help community bankers navigate that is the Friday 5. Tell us about the Friday 5. What is it and how can folks find it?

TOM: Well, basically it’s kind of a synopsis. I put out something called the Market Update three times a week, Monday, Wednesday, Friday. And so, the Friday 5 is a way to kind of summarize some of the more key findings in the market update of that past week. And so, it goes out in a bulk e-mail, but then basically you can kind of link to stories that are on the web if you’re interested. And so, we give you 5 items that we think are most important. If you like it, click on it takes you to the to the website and to that web edition of that market update.

CALEB: I kind of think of it like it’s our own version of the Wall Street Journal 10-Point. If you don’t have a lot of time and you just need a quick little summary of the news and the, you know, economic world for that week, you can scan the five bullet points. If you want a deeper dive, you can click on one of the items and dive a little bit more into the details of what went on in the in the market, in the economy. And so, if folks want to get that, all you have to do is click the link in the show note of this episode, or go to SouthStateDuncan.com and click on the market update link and you can subscribe there as well, so I hope you will check that out. And now Tom, you sat down with Lelia Coggins from SouthSouth | DuncanWilliams, our broker dealer here at the Bank. Talk about that conversation and what all you guys discussed.

TOM: Well, Lelia is one of our chief strategists in the Memphis office, and so we want to just kind of get, you know, kind of go over where we see the economy now and where we see it headed into 25. And then based on that, what are some investment recommendations that could work in that environment? And so Lelia kind of gives us some really good insight into some of the different strategies that could be employed, you know for different clients that have different needs. And so, I think it’d be an interesting listen for those that have been wondering what to do once the Fed starts to move rates lower, which is probably coming closer than many of us think and it could be coming as close as next month.

CALEB: Yeah, fantastic. Well, we will go to that conversation right now.

TOM: Well, hello, everybody. I’m Tom Fitzgerald. And today I am joined by our lead strategist, Lelia Coggins. Lelia is in our Memphis office. So, first question, Lelia, welcome back. It’s been a few months since you’ve been on the show and plenty has happened, but it’s nice to get you back and, you know, so how are you doing? How’s the weather in Memphis and all that stuff?

LELIA: Hey Tom, thanks for having me. I’m definitely glad to be back on this show. Things in Memphis are great, you know. It’s time for fall to start. Kids are back in school. Football’s around the corner, and the markets are proving to be anything but calm and ordinary. So, it’s going to be a nice, busy fall.

TOM: That’s the same story here. Kids are back in school. All the routines have had to shift from the summer season. So, it’s—and like you said, the markets aren’t making it any easier. I think it’s, I don’t know if it’s a Chinese proverb or what, but you know. Something along the lines of, “May you live in interesting times.” And certainly, the market has provided that over the, at least for the last few weeks. If not for the whole year, actually. And truth be told, we wanted to record this last week, but we thought that with all of the volatility, we thought, well, let’s just let it lay. Let the dust settle a bit before we kind of move into this program. But even with that one week, I don’t know that that was enough, but we’re going to give it a shot anyway. And also, as we record this, we had the July CPI numbers come out this morning, and they were basically right as expected. I think the market was hoping they would be a little bit softer. So, there was a little bit of initial disappointment, but that’s kind of traded away as the as the day has gone on. I was just going to ask you, Lelia, was there anything that you saw in that CPI report that either surprised you or disappointed you?

LELIA: I thought it was interesting that housing kind of turned around the negative way. We’ve all been hoping and waiting for that part of CPI to continue gradually showing some relief. So, I was somewhat surprised to see that housing kind of was the trigger to make CPI rise a little bit. When you look under hood, with the core numbers, but I think overall when you look at the annualized trends for the three- and six-month rate that that that was the main takeaway to focus on. Was that that is continually to move lower and is actually kind of hit those lows since 2021. So, that gives the Fed at least a little bit more comfortable, in thinking that inflation is continuing to move down, you know. We know it’s not going to be linear. So, we will have some times where it could pop back up. But I think again to see those longer term trends reach those lower levels is definitely a positive sign.

TOM: Yeah. And I think I agree with all that. And again, like you said, that OER, that owner’s equivalent rent, kind of ticked back up again when we thought it was finally rolling over for good. So, it continues to be sort of a source of frustration. But yeah, bottom line, I think it’s good enough to where it keeps the Fed on track for a rate cut in September, and so they’ll get one more CPI report and then a jobs report before their September meeting. But it didn’t by any means derail any possibility of a rate cut, so I think that’s still going to be in motion. One of the things I wanted to mention too, and what we’ll do is try to kind of cover some of what we’ve seen in the economy and what we’ve seen from interest rates and then kind of roll that into recommendations at the end. What really, you know, got kicked off the volatility was a soft ISM manufacturing number followed by a soft jobs report from July and then that really got the ball rolling. And then, of course, you can talk about Yen carry trades being unwound and stuff like that, that just sort of fed into the volatility with stocks selling off, you know, basically globally. And then yields kind of being you know, the beneficiary of that flight to quality or flight to safety.

TOM, continued: One thing that I did want to mention, the jobs report—yeah. Well, it was pretty weak. You could kind of, even though the BLS said there was no weather-related impacts ‘cause, keep in mind this is when Hurricane Beryl came into the kind of Houston area during the survey week of that of that jobs report. But when you kind of dig into the details, the response rate on the establishment survey was way down. And the number of employees who couldn’t get to work because of weather was up over 400,000 I think when that month typically averages 30,000. And so, I did see some weather-related softness, and that may get adjusted upward with the August report. So that’s just kind of something to keep in the back of your mind, you know, to think about when we do get closer to that August report. And I do think that’s kind of be the tell between a 25 or 50 basis point move. Is it going to be—how weak is that August report? If it’s if it shows as much weakness as July, if not more than the odds of a 50 do go higher. But I do think all else equal, the Fed would love to kind of just stick with the 25 and kind of keep that as their standard as we move through. Some of the other things that I wanted to mention and, Lelia, you know we’ve, we talked about this in every presentation, is that when you get into rate cutting cycles, treasury yields always sort of lead the Fed lower in rates. And so, by the time you see that first rate cut, you’ve already lost 1500 basis points in yield in the treasury market and the markets that trade off treasuries. And I think you, obviously, you would agree with that.

LELIA: Yeah, absolutely. And that’s something that we’ve been alluding to and trying to remind investors over the past year. What that cost of waiting entails, because when you do just kind of stay in cash or stay too short, you do really miss the boat on the opportunity to act and try to capitalize and lock in on some of these yield levels because once the market tries to price things in, it moves ahead of the Fed. It’s forward-looking, so we just don’t want to miss the vote, so to speak, because we are starting to get late cycle yields as they move down, they kind of lead, as you mentioned, lead the Fed.

TOM: Right. And I think the trend is still going to be lower and we, you know, we might have some consolidation, might have some backups here and there. But I think generally now that, you know, if somebody is looking for that four and a quarter or 4.50 10-year yield, again they may be waiting for the next cycle to come around. Also to, partly triggered some of the volatility off that jobs report was, you know, the recession odds. There’s something called the Sahm Rule that Claudia Sahm, economist, came up with. And it looks at the current 3-month average of unemployment compared to the 12-month low. And when it gets 50 basis points above that 12-month low, it’s typically has been a trigger that a recession is coming. She herself cautioned against that this time because a lot of recession indicators in this COVID-induced environment have not been that reliable. And part of the reason that the unemployment rate climbed was that you’re getting more people joining the labor force, but the hiring has slowed down to the point where they’re not getting jobs as quickly as they did before, so they’re basically counted as unemployed, even though they recently came into the labor force.

TOM, continued: So that’s to me, that’s a little better than people being laid off, and we’re not seeing the, you know, layoff rates, climbing excessively. Now when we see that, that to me will be the next shoe that fall. So far, it’s been cutting back on hours, cutting back on temporary help. And then just new entrants into the labor force having a longer and longer time finding employment. And so, like I said that to me, the next shoe, when we start seeing layoffs increase, that’s when, you know, the employers are cutting into full-time workers, and they’ve been reluctant to do that so far. And so, I think you know, again that’s something we’ll be on the lookout for. So, really, kind of to summarize that we, you know, we don’t see a recession coming in the near term. We’re still in that soft landing camp. Consumer balance sheets are still strong. Now, you have the delinquency rates are moving higher, but kind of historically speaking, I still think they’re not, you know, kind of where we were, say in the great financial recession, as far as far as levels of delinquencies, but they are inching higher, and that’s something to be something to be aware of. But at least in the near term and into most of 25, I do think we’re going to be successful in negotiating that so-called soft landing of slower growth, you know, slower employment market, but not falling into a, you know, a negative GDP situation. Is that similar to two-year outlook as well, Lelia?

LELIA: Yeah, I would say so. And I’m not just agreeing with you because you’re the chief economist and you know more about the—or you’re more of an expert in that area than myself. But I’ve gradually been shifting more in a soft landing camp over the course of this year just due to some of the stronger economic data that is coming through. And outside of an event that is unforeseen, currently, I don’t see what would cause a large pullback or slow down to get us to those technical recession levels. One thing that does caution me though, just in knowing the chances of hitting the soft landing, I always am reminded of the Fed’s ability to conquer such a feat. The track record isn’t great, so that always kind of leaves a little bit of self-doubt in me, just knowing that they’ve only successfully completed it once in the early 90s, when inflation was not high and not part of the issue with the economic backdrop.

LELIA, continued: So, that part, you know, does kind of give me maybe a 10% allocation to maybe we somehow trigger that technical recession, but I still see a majority of that we just kind of skirt by. But I do also then think if we do, if the Fed is able to achieve this, which I am leaning towards like yourself, and what that means: maybe a bit longer term. You know, does that mean then in a year to two, or we would then start to see a possibility of the of recession landing? Then, just as I look back and think what happened after the Fed accomplished that feat, four years later we had the .com bubble that did send us into a recession, so I have been cognizant of that risk out there. But, I’m still in the soft landing camp too.

TOM: Yeah. And I agree. Like you said, the only, I guess the concern I would have is the Fed overstays their welcome, and, you know, kind of continues to resist rate cuts, but I think they will relent in September, and that’s kind of where we go from here. Is, you know, what will the Fed do? I think the full employment mandate to me is now on equal footing as the inflation mandate. You know, for the last two years, it’s been all about inflation, you know, and the full employment part of their mandate has been kind of sitting on the bench, you know, waiting to get into the game. And now they’re getting into the game as far as equal, you know, equally looking at inflation and equally looking at you know, how is the labor market doing? And so again, I go back to that August employment report, if it comes in weak or weaker than July, then certainly I would think that, you know, then you would start talking maybe 50 basis points of rate cuts.

TOM, continued: The one thing interesting is next week, the Jackson Hole Symposium takes place, which is where you have a lot of the, or I guess most of the central bankers of the developed economies around the world meeting. And that’s typically where the Federal Reserve, if they want to kind of make a big policy pronouncement, they make it there. I don’t think he’s going to come out and say we’re going to be cutting, you know in September, but I think you know, he could at least provide a little more clarity on where they are thinking versus kind of what we’ve been listening to for the last year as far as higher for longer, you know we need more confidence, we need more data. Hopefully that message starts to shift, and I think Jackson Hole could be a good place to start that shift. One interesting thing too, and I’ve talked about this a little bit in some of my market updates, is the BLS next Wednesday, which is the day before the Jackson Hole meetings, they do an annual benchmarking. They get more complete, actually comes from the unemployment insurance data that apparently covers every employer in the country, and so it’s a lot more comprehensive than the monthly numbers that we see from the jobs reports. So, what they do is they take that comprehensive data and benchmark it back to March, and so we’ll see an adjustment of not the number of employed people in that adjustment, and there’s been some estimates that it could be anywhere from 400 to 800,000 lower employees.

TOM, continued: There’s talk that the birth-death model in the serve and establishment survey is overstating the number of new companies being created, and so if that gets sort of revised down and you have 400, 800,000 less employees than you thought you had, that to me, that’s another, you know, that’s another catalyst to get them to cut in September. And also, to me that’s another catalyst for probably lower rates. So, I just kind of throw that out there to be on the lookout for next Wednesday when that hits the tape, to kind of see how the markets react. But anyway, kind of what I see is that they do cut, and right now I’m sort of in that 25 basis point camp, but I could easily be shifted higher, you know, given you know the data that comes out between now and September. And I think they cut again in December, again hoping to do the 25 is where they are. And then every quarter in 25, 25 basis points, and so adding up to a full percentage point and getting us down to about a 4% funds rate at the end of next year.

TOM, continued: The market is a little more aggressive than that. I think the market still has two more cuts priced in during that time, so like 350 on the funds rate. So, I’m, you know, the market again still trying to lead the Fed, but I don’t know if they’ll be, you know, if that’s if they’ll be successful in that regard. So, I think you know, we’ll have to see how that plays out. Do you feel comfortable with that, Lelia? Do you feel comfortable kind of with where, you know, where the market is, pricing fed funds or do you feel like it’s a little bit aggressive?

LELIA: I think, consistent with how the Fed funds market spent the whole time pricing and the cut to this cycle, I think it’s leaning more on the aggressive side. I don’t see anything materially that stands out right now that would cause the Fed to panic, so to speak. They want to remain the sense of calm in the market and not feed this doom loop that could actually spark a more material decline in conditions. And so, I think they’ll come out and confirm their conviction. That there’s no need or panic to do a heightened rate cut or emergency rate cut, either one of those. I think they’ll do the 25 basis points in December. And then try to just slowly 25 basis points, another one in December and then stair step it down quarter over quarter until they kind of get back to maybe, you know, the federal funds rate in the in the threes somewhere over the next 18 months. But, you know, things that things could definitely derail that and cause them to maybe cut a little bit faster, but I think they’ll be gradual and patient and do it in in slower increments.

TOM: Okay, well with that, so with our background, our scenario, soft landing kind of quarterly rate cuts beginning in September going through next year. Kind of give us some of your thoughts on investment strategies in that environment and where you would, you know, sort of play given, you know, the outlook. You know, we might have some listeners think, “Well, I think there’s going to be a hard landing.” Maybe talk about a strategy and that’s, you know, for that scenario, but, you know, kind of given what we have laid out here, give us some of your thoughts on what you think would be a successful, you know, investment recommendation going forward?

LELIA: Yeah, absolutely. Now, I’ll start this out, but I’ll say you know, the recent price action in treasuries and yields moving down has been fairly remarkable. It’s happened fairly quickly, even though we did see a pullback last week in yields. They’ve quickly drifted back lower on the data releases this week, and we’ll get retail sales tomorrow. So, it’s just kind of a “stay tuned” event here, in looking at what portfolio managers are thinking, it hasn’t really altered what their thoughts are in managing the bond portfolio, but it has begun to kind of put a sense of urgency and start the shot clock on executing a lot of the strategy discussions that these accounts have been having for the first half of the year. And the current data, you can pretty much find economic data points and jobs data points to support either the soft-landing narrative, as we kind of lean towards, or you could find other data points to support a greater probability of a recession.

LELIA, continued: And so those are those are broadly speaking the two camps that investors really still find themselves in, but I what I want to state is kind of more important or more broadly of the concept to really think about is: regardless of what camp you sit in, if you think there’s going to be a recession or a soft landing, the outcome of both and the progression of both places downward pressure on yields. So, whichever camp you are in, the probability that yields will be moving lower in the near future and throughout next year is going to be top of mind. And so, we’ve talked about that a lot over this past year. The concept that we are late cycle, how the change in an economic cycle impacts the change in yields and the yield curve shape. And we start to see some of that play out. Recently we’ve seen that the curve has been steadily re-steepening. And this has been more broadly seen in the belly of the curve, and that should be the area of the curve that continually sees the greatest gradual unwind of those inversions as it re-steepens, when the Fed looks to cut rates next month.

LELIA, continued: And so, since we are anticipating that first cut next month and the market does try to lead in front run and is forward-looking in front of the Fed, a lot of portfolio managers are being very proactive in trying to capitalize on these larger gains from these strategies that could quickly diminish if they continue to wait. As yields have been, has moved lower, those that have been considering loss recoup strategies have come back to get indications on those bonds. Those bonds have been more lower yielding or underperformers. And today’s dollar loss level is a lot more palatable than it was back in April, when yields were at their cycle highs for this year. And when they look to do that, they’re pruning those lower yielding investing portfolios and pulling forward that future loss of income on those lower yielding securities and thereby they relieve the future drag on earnings going forward. And where do they redeploy that money? Well, they’ll redeploy it in the same way that those that find themselves maybe with excess liquidity or that have enough short-term portfolio runoff to execute a prefunding strategy by a combination of looking to securities that offer strong call protection and then in the amortizing space, those securities that have strong yields with a more intermediate term cash flow profile.

LELIA, continued: The reason the call protection lag of this current opportunity is so important is because if we focus on say the three-to-five-year part of the curve right now—so we call that the front end of the belly of the curve—this portion of the curve historically sees the greatest re-steepening during a cutting cycle. So not only are you able to lock in income today, by adding that level of call protection—so that means as rates fall, your bond does not get called away—you’re able to lock in that income, and then also give way to the opportunity to rebuild unrealized gains back in the portfolio. These unrealized gains can then be used in the future, say, if you do see a pullback in loan growth or you do start to see a more material decline in credit quality and you’re having to increase your loan loss reserves, you can utilize this portion of the portfolio to support those earnings by realizing the gains or just liquidating to support having some excess liquidity on hand for other opportunities.

LELIA, continued: To combat that, there’s been a focus on the amortizing securities that are a little bit down in coupon, but still fuller. So, say anywhere between the four to five coupon stack, and some have been moving down even deeper in coupon. But I still think the staying in the mid-range in coupons between 4 and 5%, you’re still limiting any premium. A lot, of course, the fours could still be purchased at a discount. But what you’re doing is you’re able to limit your reinvestment risk by not having a front-end weighted cash flow profile and kind of getting a more intermediate cash flow profile, but still maintain that monthly principal and interest coming off in the event that maybe rates don’t fall as quickly as we thought. Or maybe the long end of the curve starts to materially rise because of fears that we don’t really see super present in today’s environment and give way to the opportunity to put out some high longer duration items in the future. But all of that together kind of better prepares the portfolio to benefit from losing money if they do have all of their cash coming back to them as rates fall on the curve. And so that’s something that we’ve been talking about a lot earlier in April. We released something called the “Bridge Strategy” that does kind of take apart all the dynamics as we do see a shift in the cycle and what’s at risk and what you should protect within the portfolio. And call protection is a key purpose for that type of strategy.

TOM: Well, that’s a lot of good ideas, and I think, you know, most of our listeners, like you said, they’re, you know, some of them buy into the soft landing. You know, some of them probably, you know, think there’s going to be a little bit be a harder landing. But I think, you know, you’ve given them a good discussion of where you could go depending on where your outlook is. And again, just going to reiterate the fact that, you know, the treasury market is going to lead the, you know, the Fed lower in that environment. And so, if you’re thinking about doing a trade, it’s probably, you know, yesterday would probably be better than today, and today is going to be better than tomorrow. So, you know, get with your reps and make sure you kind of get the ball in motion because the market’s not going to be waiting for long.

TOM, continued: But anyway, Lelia, I want to thank you so much for your time today. I know you’re battling construction there in the office, as well as, you know, trying to keep all of your reps, you know, happy with your responses to their requests. So, I appreciate you taking some time to talk to our listeners today. And I’m sure we’ll be back in another two or three months to kind of see where we go in 25, and kind of, you know, plot out that future when we get closer to year end. So again, thank you so much for your time today.

LELIA: Yeah, thanks for having me, Tom. It’s always a pleasure to sit down and talk with you and then also provide, you know, color to our listeners and our audience. So, thank you again for having me.

TOM: Well, thank you.