Labor Market and Inflation: Shaping Bond Market Trends in Q2 2024

After a rough start to the year, fixed income markets stabilized and returned to positive territory. The second quarter of 2024 began with some challenges, as the fixed income markets (as measured by the Bloomberg US Aggregate Bond Index) lost -2.53% during April, the biggest monthly drop since September 2023 (down -2.54%).

Ongoing strength in the labor market and stubborn inflation pushed rate expectations further and further into the future and cemented the Fed mantra of “higher for longer.” Even as grumblings continued to grow for a possible rate hike before year-end, Jerome Powell used the FOMC meeting at the beginning of May to push back on the idea, assuring markets that the Fed’s next move was most likely lower, barring any significant shift in economic data.

The June meeting served as another opportunity for the Fed to reinforce the higher for longer approach to interest rates. It did so with the Statement of Economic Projections (which includes the dot plot) indicating a reduction of expected rate cuts — from three 25-basis point (bps) cuts to one 25-bps cuts by year-end 2024 and from five 25-bps cuts to four 25-bps cuts in 2025. The resulting rebound in the fixed income markets in May (+1.70%) and June (+0.95%) helped bring the quarterly return into positive territory for the quarter (+0.07%).

The only other significant development from the Federal Reserve during Q2 was the announcement that the Fed would slow the reduction of Treasury holdings, starting the process in June. The Fed set a monthly redemption cap of $60 billion for Treasury securities, meaning that anything greater than $60 billion in maturities would be reinvested into the Treasury market. That redemption cap has now been reduced to $25 billion, meaning that only $25 billion, at most, will roll off the Treasury balance sheet monthly starting in June. While the cap for Treasuries has been reduced, the cap for agency debt and agency mortgage-backed securities remains unchanged at $35 billion. According to the New York Federal Reserve, the FOMC balance sheet has decreased from $8.4 trillion in June 2022 to its current level of $6.6 trillion at the end of the second quarter, with roughly 79% of the roll-off coming from Treasuries and the remainder from RMBS.

Exhibit 1 — Bloomberg US Aggregate Bond Index Monthly Returns (%)

Source: Bloomberg.

The labor market continues to exceed expectations even as the narrative of a soft landing continues to dot the landscape. Even considering revisions made to initial readings that reduced the number of jobs added to the economy by 250,000, the addition of 1.3 million jobs (estimated 1.2 million) since the beginning of the year is welcome news. Over the past 20 years, the labor market has averaged roughly 112,000 jobs added monthly; before 2020, the average was 107,000.

The steady, if slow, reduction in inflation (Core CPI, which excludes volatile food and energy components) continues with Q2 data coming in at 3.6%, 3.4% and 3.3% on a year-over-year basis from April through June, respectively. It is a welcome continuation of the gradual decrease since the beginning of the year when it stood at 3.9%. The inflation data continues to reinforce the dovish messaging from the FOMC and offers confirmation that the Fed’s tighter policy stance is weighing on consumer price inflation.

Exhibit 2 — Nonfarm Payrolls (in thousands)

Source: Bloomberg.

The most recent June data enforce the expectation of inflation continuing to come under control, pushing market expectations for the first rate cut from the end of the year to September. The FOMC meeting at the end of July appears to be a “hold the line” type of meeting, barring any significant geopolitical or economic shift, and there is no meeting in August.

In place of an August meeting, the Kansas City Fed hosts the Jackson Hole Economic Symposium in late August. This is traditionally viewed as an opportunity for the Fed to lay the groundwork for future action. This meeting comes into even greater focus as it will be the most opportune time for the Fed to communicate any potential shift in rate policy for the final four months of 2024.

The September timing presents an interesting dilemma as it is only 48 days ahead of the Presidential election. Still, historically, the Fed has shown a willingness to act in the months leading up to an election, having raised rates twice and lowered rates three times in the month immediately preceding an election year.