To Hike or Not to Hike — Transcript

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1. 0:00Welcome to Thoughts on the Market. I'm
2. 0:02Matthew Hornbach, Global Head of Macro
3. 0:04Strategy at Morgan Stanley.
4. 0:05>> And I'm Michael Gapen, Chief US
5. 0:07Economist.
6. 0:08>> Today, the challenge facing the Fed to
7. 0:11not hike rates while still convincing
8. 0:13investors [music] that you think rate
9. 0:15hikes are coming.
10. 0:17It's Tuesday, October 27th at 11:00 a.m.
11. 0:20in New York.
12. 0:23So Mike, how do you think the Fed and
13. 0:26Chairman Warsh in particular is going to
14. 0:30deal with this challenge?
15. 0:32>> Well, I think that the way that he can
16. 0:34do it is to say,
17. 0:36"Obviously, we already did hike, so
18. 0:38we've started a process. You know we're
19. 0:41serious about bringing inflation down in
20. 0:43a timelier fashion."
21. 0:46So essentially, the question is, do we
22. 0:48want to raise rates at every meeting
23. 0:50or do we want to take an action, assess
24. 0:53incoming data, and take a different
25. 0:55action?
26. 0:57So I do think that the message here can
27. 0:59be balanced in a way that says, "We
28. 1:02didn't hike rates today. We didn't feel
29. 1:04a tremendous sense of urgency to raise
30. 1:07rates today,
31. 1:08but we we think more work is needed." So
32. 1:11I'm not sure that there's urgency to
33. 1:13raise rates every meeting, but you can
34. 1:15still suggest that rates are going to go
35. 1:17higher. You can see I'm having trouble
36. 1:20articulating the the story as well.
37. 1:23Warsh may have some of the same
38. 1:24difficulty, but I think that's the basic
39. 1:26message is taking an action, assessing
40. 1:29an effect, deciding to take another
41. 1:32action.
42. 1:33>> At the Jackson Hole Symposium in August,
43. 1:37Chairman Warsh gave a speech and in the
44. 1:41speech, he invoked this imagery of going
45. 1:45on a hike around the mountains of
46. 1:48Jackson Hole.
47. 1:49And he told us that there were, in
48. 1:52essence, two types of hikes that one
49. 1:54could go on around Jackson Hole, a more
50. 1:56leisurely hike and a more aggressive
51. 1:59hike around the mountains.
52. 2:01Presumably because we don't think the
53. 2:04Fed will hike rates at this meeting.
54. 2:06Presumably the idea that he has in his
55. 2:09head today is to go on a leisurely hike,
56. 2:11but if that's the case, how long does a
57. 2:15leisurely hike last? How long will we be
58. 2:17hiking?
59. 2:18>> yes.
60. 2:19So, I think that I would interpret the
61. 2:21leisurely hike also as the difference
62. 2:23between I think what economists
63. 2:26euphemistically call a recalibration
64. 2:29of the policy stance as opposed to a
65. 2:33more aggressive tightening cycle.
66. 2:36So, one's kind of leaning against the
67. 2:38wind while the other one is trying to
68. 2:40change the course of the economy. So, I
69. 2:44think you're right. He called the
70. 2:45leisurely hike the Ben Bernanke hike
71. 2:48as opposed to the Don Cohen aggressive
72. 2:50hike that's inside Fed speak if you know
73. 2:53your former Fed staff.
74. 2:55And I think what the data is telling the
75. 2:58Fed on one hand growth is certainly
76. 3:00resilient and inflation is sticky.
77. 3:03But the labor market doesn't look like
78. 3:05it's overheating. We're only adding
79. 3:07about 50,000 jobs a month. The
80. 3:10unemployment rate is low, that's true,
81. 3:12but wage growth is actually
82. 3:13decelerating.
83. 3:15So, from my perspective and I think
84. 3:18their perspective even with the AI
85. 3:20investment boom, there's not a lot of
86. 3:22evidence the broader economy is
87. 3:24overheating and that's where I think the
88. 3:27urgency story fits in. Are they behind?
89. 3:30Do they need to get on top of something?
90. 3:32I think the answer to that is no. So,
91. 3:34you end up with this measured
92. 3:37recalibration. Hey, we cut 75 basis
93. 3:40points last year to support the labor
94. 3:42market.
95. 3:43We should probably reverse those. That's
96. 3:45what we should be thinking. We're not
97. 3:47thinking we need to go all the way back
98. 3:49to 2023
99. 3:51highs, which would be the more
100. 3:52aggressive tightening cycle. That's the
101. 3:54way I split it out.
102. 3:56>> So, what would have to happen with the
103. 3:59weather in Jackson Hole to change the
104. 4:03mind of the committee to go on a more
105. 4:06aggressive hike, maybe to get back into
106. 4:08the lodge before the weather really
107. 4:10turns inclement. What would have to
108. 4:12happen in the economic data, do you
109. 4:14think, to to change their mind?
110. 4:16>> Well, I think that the most likely story
111. 4:19there, I mean, what macro data would
112. 4:21make them do that sooner than later
113. 4:23would just be inflation has a lot more
114. 4:26momentum than they think.
115. 4:28Rather than being flat or decelerating
116. 4:31slowly, it actually starts to firm. So,
117. 4:33the actual data that they have in hand,
118. 4:35they wouldn't even have to decide where
119. 4:37it's coming from, but if inflation's
120. 4:39firming, they have to get on top of it.
121. 4:41That could certainly shift them to hikes
122. 4:42every meeting.
123. 4:44So, I'll put that down as the most
124. 4:45likely.
125. 4:47The other would be just what I said
126. 4:48about the labor market. You would need
127. 4:50evidence that says, "Wow, look at that
128. 4:53labor market. Employment growth is
129. 4:55picking up. The unemployment rate's
130. 4:57moving lower,
131. 4:58and wage growth is turning and starting
132. 5:01to firm." So, that would tell you
133. 5:03what was kind of a narrow business
134. 5:04spending story is now a broad-based
135. 5:07overheating story. That's likely to be a
136. 5:09much more slower-moving train, but
137. 5:11certainly that could get the Fed to more
138. 5:13rate hikes in 2027 than we're thinking.
139. 5:16>> On the inflation point that you're
140. 5:18raising here, one of the statistical
141. 5:22quirks in how the Bureau of Labor
142. 5:25Statistics and the Bureau of Economic
143. 5:27Analysis
144. 5:29put together the inflation data
145. 5:31is that in the first month or two of the
146. 5:35year, you typically have seen the
147. 5:38seasonally adjusted inflation data come
148. 5:41in much stronger, and then in the final
149. 5:44couple of months of the year, you've
150. 5:45tended to see inflation data come in
151. 5:47lower than what you might otherwise
152. 5:50expect because these statistical
153. 5:53agencies have had difficulty properly
154. 5:56seasonally adjusting the data. So,
155. 5:58presumably, because this has been going
156. 6:00on for a couple of decades, we'll see
157. 6:03this {quote} residual seasonality
158. 6:06{unquote} again in 2027.
159. 6:09Of course, we may not, but if we do, how
160. 6:11do you think the Fed will deal with
161. 6:13that? Because that could very well show
162. 6:16us that inflation is picking back up.
163. 6:18>> That residual seasonality, you're
164. 6:19correct, it's still present in the data.
165. 6:21There are many firms in different
166. 6:24industries that raise their prices once
167. 6:27a year. It varies over time. That's why
168. 6:29the seasonal adjustment process doesn't
169. 6:31capture it. So, we get big, kind of
170. 6:34one-off annual increases in January and
171. 6:37February. The Fed knows this, you know
172. 6:39this, I know this.
173. 6:40But the point is to decide either to
174. 6:43stop raising rates or maybe even at some
175. 6:45point to cut rates,
176. 6:46you have to ascertain where the
177. 6:48underlying trend is. So, this makes it
178. 6:50harder for them to know kind of what the
179. 6:52underlying trend is. So, in our view, it
180. 6:54actually means
181. 6:55you still get one additional rate hike
182. 6:57in March.
183. 6:59Then after that, it only starts to
184. 7:00become clear that inflation is
185. 7:02decelerating and the Fed stops hiking.
186. 7:05So, in my view, I think the way that
187. 7:06they deal with it is they have to wait
188. 7:10and get more data to decide that
189. 7:12inflation's either going in the
190. 7:13direction they want or it's not going in
191. 7:16the direction they want.
192. 7:18So, Matt, I'd like to turn it back to
193. 7:19you if I can. We We've seen a lot of
194. 7:22volatility in the Treasury market. As
195. 7:25you know, for for many months, yields
196. 7:27were backing up. The 10-year Treasury
197. 7:28yield peaked above 5 and a quarter. It's
198. 7:31now back down to about 5%.
199. 7:34How do you read what's happening in the
200. 7:36Treasury market today?
201. 7:38>> So, the biggest explanatory factor in
202. 7:43the sell-off in the Treasury market,
203. 7:46really since the beginning of March,
204. 7:48has been a combination of what has
205. 7:51happened with energy prices, both
206. 7:53outside of the country and within the
207. 7:55country,
208. 7:57and then how the central bank ended up
209. 8:00shifting its perspective on rate policy
210. 8:03as a result of
211. 8:05the effects of these higher energy
212. 8:07prices on underlying inflation. So, as
213. 8:10the Fed transitioned from easing
214. 8:13monetary policy in 2025 to now
215. 8:15tightening monetary policy in 2026
216. 8:19and on your forecasts into 2027
217. 8:22the bond market had to reprice. And this
218. 8:24is a a typical behavioral response to a
219. 8:28big change in monetary policy
220. 8:31expectations. The more recent price
221. 8:35action in the Treasury market where the
222. 8:3610-year yield went from 5% up to 5 and
223. 8:391/4%. We think was driven much more by
224. 8:43technical flows related to a very large
225. 8:47fixed income market place that includes
226. 8:49more than just US Treasury securities.
227. 8:52Of course, we have agency
228. 8:54mortgage-backed securities. There's a
229. 8:56huge corporate bond market as well. And
230. 9:00so, we see the last 25 basis points
231. 9:04as more of a technical dynamic that was
232. 9:08driving yields to those peak levels. And
233. 9:11once those technical flows
234. 9:14stopped, then we saw yields settle back
235. 9:17down to a level that was more aligned
236. 9:21with fair value given how the Fed is
237. 9:25expected to behave with monetary policy.
238. 9:29What what that means, though, is that as
239. 9:31the data come in over the course of the
240. 9:34next several quarters how the market
241. 9:37thinks about the path of Fed policy over
242. 9:41the course of 2027 will become an
243. 9:43increasingly important factor in the
244. 9:45Treasury market once again. So, if the
245. 9:48investor base decides that maybe the
246. 9:51Fed, after having delivered these rate
247. 9:53hikes that you're expecting is
248. 9:55comfortable keeping rate policy where it
249. 9:58is and as the disinflationary process
250. 10:02resumes might even consider reversing
251. 10:06some of these rate hikes that they have
252. 10:08put into place. I would expect 10-year
253. 10:10Treasury yields to to fall alongside of
254. 10:13those expectations for monetary policy.
255. 10:16So, ultimately, we have had a big move
256. 10:18in the US Treasury market this year. It
257. 10:20has been very much aligned with how
258. 10:23investors have thought about the
259. 10:25changing narrative around Fed policy.
260. 10:29And so, 2027 will likely hold more of
261. 10:32the same. As we make our mind up about
262. 10:35where the Fed is heading with monetary
263. 10:36policy, we will very likely see the bond
264. 10:38market move in sympathy with that.
265. 10:42And I guess we'll keep an eye on
266. 10:45inflation,
267. 10:46the labor market, as well as the
268. 10:48Treasury market as we look forward
269. 10:50towards the next FOMC meeting in early
270. 10:52December.
271. 10:54And considering the question again, hike
272. 10:57or no hike?
273. 10:58Thanks for this, Mike.
274. 10:59>> Thanks for having me on, Matt.
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