Fed Week: To Hike or Not to Hike, That is the Question

Lawrence Gillum (00:10):

Hello, and welcome to LPL Market Signals. I'm Lawrence Gillum, Chief Fixed Income Strategist at LPL Financial, and I am your host this week. And this week is a busy one from an economic calendar perspective with PCE and GDP releases, and also from an earnings perspective, over 170 S&P 500 companies will report earnings this week, including four Mag Seven companies, Amazon, Apple, Meta, and Microsoft. But probably most important for markets this week, it is Fed week. The FOMC meets, the Federal Open Market Committee meets this, Tuesday and Wednesday with the statement at 2:00 PM Eastern on Wednesday and Chair Warsh at the podium half an hour later. Markets aren't expecting a change in policy rates this week, but there's a long time between today as we record this on Monday afternoon, and Wednesday afternoon. So to help provide some color on what investors could expect this week, I am joined by Andrew Norelli, managing director and portfolio manager for multi-sector fixed income at JP Morgan Asset Management.

Lawrence Gillum (01:10):

Andrew, thanks for your time today, and it's great to have you on the program.

Andrew Norelli (01:13):

Thanks, Lawrence. Great to be with you and with our listeners.

Lawrence Gillum (01:16):

So it is Fed week, as I mentioned. Markets are kind of sanguine in terms of rate changes this week. But I am curious to kind of see how you're thinking about this week as it relates to not only any potential change in interest rate policy, but what you're expecting to hear or see at the statement and the press conference as well.

Andrew Norelli (01:37):

Okay. So not to bury the lead, I think it's probably most likely that the Fed is going to keep rates on hold this week, but to set the stage a little bit, we have a 35% chance in the fed funds futures or the SOFR futures market for a hike this meeting and a 70% chance in the price for the September meeting. So that's more than 100% chance across the two meetings that you'll get at least one hike, and I think that's about right. But I also want to make a distinction between what I think the Fed will do and what they should do. They should be hiking and they should start this week. And if you take as a given that the current monetary policy stance of 3.6-ish on the fed funds rate is below the neutral rate and therefore stimulative to the economy, and we've had that view for quite a while, I think the neutral policy rate's around 4%, then if you take that as a given, the Fed should hike this week rather than wait, because raising interest rates is kind of like raising taxes.

Andrew Norelli (02:42):

Nobody likes it, and the whole of the financial industry is incentivized for lower rates because it makes asset prices go up. But every once in a while, higher rates, much like higher taxes, are necessary. And I do think we're in one of those spots. And if they, again, if we take as a given that rates should be higher because the economy doesn't need any stimulus right now, the ultimate terminal rate, how far this hiking cycle would need to go in terms of how much they would need to hike, is higher if they wait. So, from my perspective, I think they should go ahead and hike, and we can get into some of those reasons in a little bit. But I think they probably will try to hold off for one more meeting, and the reason the justification for that would be the ice cold inflation print we got for June CPI.

Andrew Norelli (03:30):

I think that print was an anomaly, but we can get I got a lot of thoughts behind all of that, if you want to dig any deeper. But, for now, I think the Fed's probably not going to hike this week. That makes September very likely, and so that probability from September will just go from, you know, 70 to 100. And so if they don't hike, which is my expectation, the market may not actually move that much other than some curves deepening to take out that very, very near-term probability that's in the price right now.

Lawrence Gillum (04:00):

Great, great stuff there. And I definitely do want to unpack how you're thinking about the inflationary story as well, because I know you've done a lot of work on that. I am curious on your thoughts. I mean, the markets have priced in, call it two rate hikes through early next year. Yep. But as you mentioned, roughly a 40% chance of a hike two days from now. That seems high.

Andrew Norelli (04:21):

It is high. And the last time we went into a Fed meeting with some ambiguity like that in the pricing was, I believe, September of 2024. And in that particular meeting, the market was debating whether they were going to cut rates by 25 or 50, and they ultimately cut by 50. But I can't actually remember the last time we went into a meeting with a material probability of hike in the price, or interest rate increase, that's ambiguous like this one is. And even though my expectation is that they probably won't, I already said I think they should. So <laugh> going in at 35% chance, and it, you know, depending on where, what time of day we're talking about, I think that's about fair. More likely than not, they stay on hold, but there's definitely a chance that they go ahead and hike.

Andrew Norelli (05:14):

But I don't think that should be bad news. Market won't like it initially, but I think it's what's appropriate at the moment.

Lawrence Gillum (05:21):

With regard to the rest of the committee, in June's dot plot, we had nine of the 18 participants, penciling in at least one hike this year. Are you looking for some dissents this meeting?

Andrew Norelli (05:34):

It's possible. I'd say that if there are going to be dissents, that the most likely scenario would be if they keep rates on hold and there are some dissents in favor of going ahead and hiking. So, Hammack and Logan, have been pretty clear that they believe that monetary policy is too loose and now's the time to raise rates. And they'll say it nicely by saying we're just going to take out the insurance cuts that we did last year when the labor market was weaker. But if we're going to get dissents, that's, I think, the most likely outcome. Now, if they do hike, maybe you get a dissent to the dovish side. But I think if we're going to get some, it would be hawkish dissents.

Lawrence Gillum (06:21):

Yeah, I tend to agree with that as well. I mean, it does seem like they're a pretty divided committee, but really no one is arguing for rate cuts at this point. So, we'll have to see how it plays out. I am curious, though, you mentioned that you do agree with market pricing of two hikes over the next 12 months. Is this, in your view, a start of a new rate hiking campaign ala late 1990s versus just maintenance hikes similar to what other central banks are doing?

Andrew Norelli (06:48):

I think it's going to be the start of a hiking cycle. And that's controversial, but here's my rationale. All right? The Wall Street sell-side economists believe that the neutral policy rate, overnight rate that's neither stimulative nor restrictive to the economy, the neutral rate, the R-star, all those things mean the same. That economics community thinks it's 3%, and they think it's 3% for one reason only, because the Fed says it's three. But part of our job is to assess the communications and the actions of the Fed, which are maybe not correct. And if you look at, if you dispassionately look at the economy, what is happening? You have stocks near all-time highs, credit spreads near all-time tights, meaning financial conditions quite loose, but that's justified because equity earnings outright level is at record highs, and the earnings growth is double digits and accelerating.

Andrew Norelli (07:40):

And I don't just mean for the S&P or the tech stocks. I mean, for the economy as a whole, the national income accounts, corporate earnings growth is 10% and accelerating through the first quarter of this year, year-on-year. On top of that, you have the labor market is actually improving, and I know that's still up for debate in the macro community, but I don't think it should be up for debate anymore. And perhaps we'll talk about that in the future in this episode. But labor market healing. And then until we got that ice cold print in June, inflation was accelerating in the U.S. and not just the war-affected commodities, not just the tariff-affected commodities, but we had demonstrable demand-pull inflation in super core, core services ex-housing, which is the place you should see demand pill inflation showing up.

Andrew Norelli (08:24):

And I've got two more things to say to add to that, which is I think further evidence that the neutral policy rate is higher than three, and in fact, higher than 3.6. I've been arguing for 4% neutral for the better part of the year. And when the Fed cut through 4%, what happened? Inflation stopped going down, the labor market started to heal, equity earnings growth accelerated, the exact sort of thing you would expect to see if monetary policy is stimulative, not restrictive. Now, on top of that, two more important points to make. The first is that market and the world understands that wars are inflationary. Yes, that's news to no one. But in the United States, this war is also stimulative. Again, you'll hear sell-side economists say, "Oh, every time fuel prices, energy prices go up, that's a headwind to growth, and we should revise down our growth forecast." That is wrong.

Andrew Norelli (09:14):

And if you want to see why, consider the economy of Saudi Arabia. What happens to the GDP of Saudi Arabia when oil prices go up? It goes up a lot. And because fuel is domestically produced in the United States, and we've been a net exporter for quite a while now, and net exporter in size. Higher oil prices are stimulative to the U.S. economy. Our GDP goes up when oil prices go up, definitely on a nominal basis. And to the extent there is any substitution away from imports toward fuel consumption, that has a positive real GDP impact in the United States. And I believe that's part of why the labor market has continued to improve, why corporate earnings growth continue to accelerate, why the labor market continued to heal. So that too is adding the lore, weirdly, but I'm convinced of it, is adding stimulus to the economy and not just security and resiliency capex on top of AI capex, but also directly because of higher fuel prices are again, in my view, stimulative to the U.S. economy.

Andrew Norelli (10:20):

Now, the last thing, it is still up for debate, but I do not believe it should be, that productivity growth raises the neutral rate. So you'll hear people say, sometimes people in positions of power, "Productivity growth is disinflationary, blah, blah, blah. Therefore, the Fed should cut rates." Only the first half of that sentence is true. And when productivity growth rises, there's 150 years of academic evidence that suggests that the neutral rate also rises when productivity growth rises. And you don't need to understand academic economics or Greek letters or any of this if you think about it intuitively. If the productive capacity of the economy increases, then the demand for capital also increases. So companies and households can put capital to more productive, meaning profitable, use per unit of time. And if the profitability per unit of time increases, then the willingness of the households and firms to use capital increases, and so too does the cost of capital because the supply increases at a slower rate.

Andrew Norelli (11:29):

So that's true of the cost of equity capital, debt capital, callable, non-callable, domestic or foreign, and it also includes Treasury yields. And lastly, lots of folks in positions of power prognosticating on the macro environment will compare this to the late '90s when Greenspan correctly anticipated the productivity gains from the internet boom and held off on hiking rates. Correct. But he hiked rates eventually, and the 10-year yield was 6.5% and the long-bond yield was seven. The only way for the United States economy to sustain higher base rate is through productivity increases, and those productivity increases are happening.

Lawrence Gillum (12:12):

That's all great commentary. I really appreciate that, because it's counterintuitive to the consensus narrative, particularly if you listen to Kevin Warsh and those folks that say that AI is going to be disinflationary, thus we need to get higher productivity levels, so we need to get rates lower, but -

Andrew Norelli (12:31):

Yeah, dead wrong.

Lawrence Gillum (12:32):

You're directly pushing back on that.

Andrew Norelli (12:35):

Well, I am directly pushing back on it. It's still, it's still up for debate. And if you want to make the argument that productivity growth is going to reduce the neutral policy rate, you must also, at the same time, in my opinion, make the argument that this productivity growth is going to lead to undesirable outcomes in the form of an increasing Gini coefficient, vast and growing wealth and income inequality in the United States. And if that were to happen, then yes, we would, it would put downward pressure on the neutral policy rate, downward pressure on interest rates in general, but that would not be an environment that any of us should look forward to. And my opinion on the matter is completely the opposite of that. And I'll try and flesh it out quickly because I know we want to talk about other topics, but this group of people, Citrini Research published a paper, many of our viewers maybe saw it earlier in the year, lamenting this potential future where artificial intelligence displaces white collar workers and the owners of AI capital get massively more wealthy and everyone else suffers.

Andrew Norelli (13:40):

And that, to me, is not likely for a couple, a couple of reasons. The first, having used the agentic tools in my professional life and in my personal life, I've proven to myself that the agentic tools, and by that, I mean Claude Code, Claude Excel, Claude PowerPoint, OpenClaw, agentic tools, not LLM chatbots, but the stuff that's 2016 vintage, can massively increase your profitability. So I'm using it to build new and innovative spreadsheets in my professional life. And these things can use things like Bloomberg Excel functions, you know? <Laugh> Things that only a very narrow subset of the Excel using population has even heard of, massively productive in terms of increasing our output. But I also built a piece of software to run my home automation that I would've had to pay $80,000 for a professional installer to do, and it would've been closed source, and I did this all with Claude Code, and I did it at my house, so I'm absolutely convinced that the increase in profitability is here, but if I can somehow make more money for you all, my clients, my employer, and myself, I don't see how that leads to my firm wanting to fire me.

Andrew Norelli (15:01):

I just don't. And then when you layer on top of that the massive decline in the cost of entrepreneurship, both in terms of, you know, amount of capital and time that you need, as well as number of employees. So that's happening right now before our eyes. If you were a coder that worked for one of these over-levered software businesses in the private credit market and you got fired, some of those folks are going to go work for their former clients and build bigger, faster, cheaper versions with the agentic tools at their former clients of their former product. But some of them have known for their whole adult life that they wanted to design an app and sell it on the app store, and they will do it. They'll sit in their bedrooms, they'll sit in their garage in over two or three weeks using these agentic tools with no capital, no employees be able to produce something that's fully sellable.

Andrew Norelli (15:47):

And after they do that and they make some money on the app store, they're going to want to make more money. And the way to do that is to hire people. So even though many of the new business formations in the United States, which by the way is at a post-COVID record right now, are sole proprietorships with these agentic tools, the sole proprietorship that's powered by the agentic tool with no capital and no employees is the seed of a company that ultimately does lead to capital formation and hiring. That I can almost prove. The number of apps on the iOS store is up over 100% year over year in terms of number of apps released. And I think that's early evidence along with that business formation number that it's true, my hypothesis, that the cost of entrepreneurship is dropping.

Andrew Norelli (16:36):

And all of those reasons are all of those facts, let's say, are reasons to anticipate that the Citrini Research outcome of mass unemployment and wealth inequality from productivity gains is hogwash. And actually, there, in contrast, is a much more prosperous outcome and one that I feel deeply is much more likely.

Lawrence Gillum (17:01):

Yeah, I definitely need to look into this Claude Code more. I'm still using these things as like, a glorified search engine, but if there's a way for me to profit off this, I need to look into it.

Andrew Norelli (17:10):

Well, that's a big difference. Like, LLM chatbots is my sort of pejorative way to refer to the AI tools of 2025 and prior. You know, better Google search. Yeah. But what's available this year is massively different. I might have thought it to be impossible last year. But the companies have already done it. And these things that they've produced have real value in terms of profitability per unit of time.

Lawrence Gillum (17:38):

Let me ask you this then, outside of the Fed discussion that we're having, we're seeing a lot more debt issuance come into market from some of these so-called hyperscalers. And I think the corporate index is expected to be, I think, 4% on a par-weighted basis with these hyperscalers, 8% on, like, a duration time spread basis. So kind of how are you viewing all the issuance coming to market from these companies?

Andrew Norelli (18:03):

Well, we've gotten, I would say over the past couple of weeks, quite a bit of indigestion in the data center bonds, particularly in IG credit, but it's not limited to IG credit. And folks that spend their time immersed in the corporate credit market will look at the datacenter bond weakness and say that it is supply overhang related, that the market can see lots of datacenter supply to hit the market, companies needing to borrow a lot more money in the future that they haven't borrowed yet. And that causes prices to trade squishy, spreads to widen a bit. And I do think there's quite a bit of that driving the price action. However, I do also think that the narrative that the AI model builders and hyperscalers are going to struggle to achieve the revenue that they need in order to pay for all this debt amortization and return on investment on top of that in the future is like the narrative questioning that has gained momentum.

Andrew Norelli (19:19):

And it is not possible for me or us as the market to assess whether or not these agentic tools are going to ultimately raise enough revenue to pay for the hardware and infrastructure costs. But the numbers are big. So if the U.S. economy is going to spend, you know, a trillion dollars a year for each of the next three years, and that stuff's going to have a five-year depreciation, you need 750 billion of revenue in order to give you an ROI and amortize the bonds, or the depreciation on the asset. And I don't know whether that's a lot or a little, but to put it in context, that's about the same as Amazon's global revenue in 2025. So every nickel that every man, woman, child firm spent, on Amazon products and on cloud services last year, they need to continue to spend that amount on products and cloud services in the future and spend that same amount on AI.

Andrew Norelli (20:18):

Is that possible? Sure. But is it okay or rational for the market to question that? I think we're going to go through those waves of questioning it. And I think that's been part of the underperformance of the datacenter credit and some of the AI-related equities in the last few weeks. And, you know, we got a big, a big datacenter deal pricing today, you know, multiple billion dollars, and the bonds are bouncing today. And that, and I think that strength is based on the positive news from NVIDIA over the weekend that they're going to help do some seller financing on big chunks of this capex. And so that's a positive. That news flow is a positive for the credit, and it doesn't change the, at least doesn't near term change the supply dynamic. And so, if the bonds respond positively to that, that tells you that there was some element in the prior couple of weeks of the market questioning the long-term profitability of the assets being funded.

Lawrence Gillum (21:27):

Yeah. Great, great stuff. Yeah, as you mentioned, we have seen spreads widen in those names over the past couple weeks because of maybe some concerns about some supply. But, so far, there's been enough demand to offset some of those supply concerns, currently. Real quick, you mentioned inflation earlier. I know you've done a lot of work on inflation. Unfortunately, this is only a, you know, 25 to 30-minute show, so we can't go through everything. But kind of how are you thinking about the inflationary dynamics right now? If you look at inflation swaps and breakeven rates, markets have really priced a 2% inflation rate, you know, in short order, you know, do you agree with that pricing?

Andrew Norelli (22:12):

I do not necessarily agree with that pricing, which to put it into sort of market lingo, it means the breakeven inflation rates implied as you compare TIPS to nominal Treasuries have pretty low breakeven inflation rates, which is another way of saying TIPS are pretty cheap, or that real rates are relatively high compared to nominal rates. And that is my current assessment. I think TIPS are pretty cheap. So what, how we get to this outcome, one way is to look at it rationally, which is to say that the market views the comparison between nominal Treasuries and TIPS, the breakeven inflation, as the real expectation of what <laugh> CPI is going to be over the life of that particular TIP. And there's some of that. So, if the market starts to come around to the argument I made earlier in the show about productivity growth in the future raising the neutral policy rate, that's a real rate thing, not a inflation rate thing.

Andrew Norelli (23:14):

So you would expect real rates to rise if my hypothesis about the relationship of productivity and R-star is what I said it was, positively related. And there's some of that. So, like, the 10-year, 10-year forward TIPS real yield is, like, 3.5%, maybe a little bit higher than that right now, which is very high. And that's rational if the market believes that productivity in the future is going to be way higher than it was in the past. And I've already said that I agree with that. But there's another dynamic going on with TIPS, that is when you're in a little bear market, which we have been, you know, rates have risen last few weeks. And if the relationship between TIPS and nominals was exactly fair, which bond would you rather own? The nominal Treasury or the TIP? You'd rather own the nominal Treasury because it's more liquid.

Andrew Norelli (24:07):

TIPS, in theory, should be the real risk-free asset, but the market around nominal Treasury is much bigger, much deeper, much more liquid, more transparent, and more granular. So if the price of the TIP was exactly fair, you'd always choose a nominal, which means a TIP tends to cheapen more than the fundamentals should dictate when we go through these little bond bear markets. And I think that's a big part of what we've seen going on in TIPS. And if that's my view, then implicitly, I'm saying that I think inflation is going to be higher than breakeven. And I do. And I gave some hints earlier about why demand-pull inflation being present in the CPI in the months prior to the June cool print. Another one is that inside of CPI, used cars have exhibited deflation, I think, for the last six or seven months in a row, when the actual price of used cars has been rising.

Andrew Norelli (25:06):

So, like, the Manheim Used Car Price Index is up over 7.5% year-to-date, and in CPI used cars are down to over 2% year to date. One of those two numbers is wrong. And if I'm trying to determine which one of those two numbers is wrong, I tend to look at the big picture. So I've already made the, tried to make the case as briefly as I can in this call that the neutral policy rate is four, not three. The current policy setting is below neutral, and therefore stimulative, and the neutral rate is rising because of productivity growth in the war, therefore, getting more stimulative, and the labor market is improving, and corporate earnings growth's high and accelerating. What should happen to inflation in that market environment if you're at full employment? The answer is it should go up.

Andrew Norelli (25:50):

And I think, I tend to gravitate toward big picture first principles type thinking, whereas the Wall Street economists will look at very, very, very granular detail, you know, five levels deep in CPI and PCE and try to predict the very next print based on their own data sources. And there's ways to do that sort of analysis where you actually expect, the near-term print to be on the cool side, not as much as June was, but, like, enough to give the Fed ammunition to stay on hold or not hike. But I try to think about the big picture, like, what is happening to the price level in the United States of America? Is the price level going up? And do we perceive it to be going up? Yes. Do we perceive a rationale for it to be going up?

Andrew Norelli (26:39):

Yes. Policy is loose, not tight. The economy has a lot of momentum. The war is inflationary, yes, but also stimulative. So, like, there are not forces at play right now that should be restraining the price level from rising in the economy as a whole. And while the market will react to near-term evolution of the month-to-month data, I think that risks missing the big picture.

Lawrence Gillum (27:08):

Which takes us back to your earlier comments about the need for the Fed to hike rates and to hike rates sooner rather than later. I love it when an argument makes sense completely from a full perspective.

Andrew Norelli (27:20):

<Laugh> I do try to have the arguments I make be internally coherent and consistent, and I try very hard to do that. It, you know, I like to speak authoritatively in my views, and if they're internally coherent, it helps. But of course, I can't predict the future any better than the next guy. But I do hope that our listeners feel that they're getting the real coherent, macroeconomic framework that we're using to manage portfolios.

Lawrence Gillum (28:00):

No, absolutely. I'm sure they will. I'm sure they did. And it's one of the reasons why we invite you onto the podcast today because, you know, I always learn a ton from you and, you know, you've talked to our Strategic and Tactical Asset Allocation Committee in the past, and I think you're scheduled to talk with them, with us in a couple months as well. And it's because of this type of thinking and this type of rationale. So, I appreciate that completely. I know we're up against time, Andrew, but we've covered the Fed, inflation. Anything else that's top of mind for you right now?

Andrew Norelli (28:33):

Well, the war, unfortunately, is going to continue moving markets. And the headline ping pong that we have causes market participants to chase the market in both directions. So, for example, last week, when it looked like the war was intensifying, you have oil rising probably more than it should, interest rates probably rising more than they should, levered investors buying oil into the strength, levered investors shorting the bond market into the weakness. And when the news flow stops supporting that position, even for a heartbeat, market rips back the other way. So, we're going to get a lot of that. I spend quite a bit of time trying to analyze the potential evolution, let's say, of the Middle East conflict. But I'm going to reserve. I'm going to hold that analysis because those things really are guesses.

Andrew Norelli (29:35):

And if the president and the Iranians don't know what their next move is going to be, I don't think it's possible for anyone to know. But I do think that we can look through it. When we're building portfolios, we have the luxury now, because the market is offering us an opportunity to build portfolios that have yield quite a bit in excess of cash or your typical fixed income benchmarks, and to build those portfolios in a relatively low-risk fashion, bonds that are recession resistant, as well as resistant to volatility in monetary policy, volatility in rates, volatility in stocks, we can build these, yielding portfolios that don't have very much NAV volatility despite the headline ping pong. And that's kind of the best we can do right now, but I think given all the uncertainty, but I do think portfolios like that are serving clients well in the fixed income landscape, and the market is, I think, questioning the correct composition, let's say, of the fixed income allocation in a typical balanced portfolio, and what we're trying to do is give investors what we believe is a better mousetrap for that 40% allocation and the ride so far has been much smoother and with higher yield.

Andrew Norelli (31:05):

So, we're trying to find answers

Lawrence Gillum (31:06):

Yeah, that's been our message as well, is that there's a lot of income opportunities in markets right now. You don't necessarily have to reach for yield anymore. The repricing back in 2022 was painful, but it did provide some additional compensation on a go-forward basis, four, five, 6% type yields on some of these higher quality income portfolios is realistic again and certainly something that we've been saying to our advisors and their clients to take advantage of. But we are against time. Andrew, I do want to thank you for joining Market Signals for the great insights and of course, thanks to the listeners as well, and we will see you back here again next week. Until then, hope everyone enjoys their week. Take care everybody.

Andrew Norelli (31:51):

Thanks, Lawrence. Good luck.