Weekly market update – Did the Fed change course?

I bear no crystal ball illusion and I never expect economic and financial outlooks to last over 3 months. Ideally though, I would like them to avoid the bonfire of vanities before the holiday break. The Fed, last week, had other opinions on the subject.

In its final meeting of the year, the US central bank issued its usual “Dot Plot”. This an anonymous survey of where the 19 people who make up the Federal Reserve Open Markets Committee (12 of whom vote) think interest rates will be going forward. In the run up to the December meeting, Jerome Powell and other Fed members had warned that monetary policy may not necessarily be restrictive enough, attempting to throw cold water over a bond market rally that was beginning to price in rate cuts early in 2024. Traders still felt that cuts would come early in the next year, but seasoned Fed watchers said later was probably more appropriate. Our outlook was along those lines.

Then, out of thin air, last Wednesday, the usually reserved US central bank ostensibly sided with the bullish traders and not the careful analysts who were warning that markets have a habit of getting ahead of themselves. The Dot Plot, showed three rate cuts next year, instead of one, which was the previous September survey. Rate outlooks aren’t even worth the pixel space they took on your laptop. Markets are now pricing in six rate cuts next year, beginning in March.

There’s nothing wrong with a spot of bullishness, of course. But central banks aren’t prone to that behaviour. Why? Because it’s risky. Traders tend to overreact. If central bankers are dovish, then traders become very dovish, assuming that central bankers are conservative. If the Fed thinks there will be three rate cuts next year, markets automatically price five of six. But this is not just an asset pricing game. When market borrowing rates come down too fast, it is as if the Fed has already cut rates. A 1% drop in the 30y Treasury will affect mortgage markets for the next year. By being more dovish than what analysts expected, the Fed knowingly allowed rampant speculation and the pricing in of double the rate hikes it is ostensibly planning.

This is why central bankers are generally strict. Because they don’t want to unleash market forces, and prefer to maintain a modicum of control. The Fed had already lost the long end of the curve to inflation. Now, it’s in danger of losing the short end due to lack of clarity. And if inflation rebounds, then it might have to backtrack, risking its very hard re-earned reputation as an inflation fighter.

So what happened? Why did the Fed risk unleashing the animal spirits?

Even if the central bank had a sudden dovish epiphany, where did it come from?

Was it something in the data?

Nothing markets have spotted. Inflation is coming down slightly faster than expected, but this is down to Chinese deflation and lower energy prices. Both of these conditions could change in the next few months. Meanwhile, wage and services inflation remains persistently over 3%. US growth is slowing, but most analysts feel that the American economy will avoid a recession. Delinquencies are rebounding fast, but they are near long-term averages. US peripheral banks, meanwhile, lasted the year’s pressures and are feeling healthier for it. While there are plenty of economic warning signs, which we have often mentioned in this newsletter, there is not one indicator flashing red. And, to be sure, neither the Bank of England or the ECB saw what the Fed might have seen in their own economies. A dovish Fed puts them in a bind. Even with a delay they will have to follow the Fed’s call for lower rates or risk trade repercussions from expensive currencies. Both European central banks issued rather hawkish warnings about lingering inflation. This is important. Inflation is far from the stable number it was during the years of the “Great Moderation”. After the pandemic it has become more volatile. Geopolitics threatens to destabilise energy prices.

Was it a pre-election decision?

A popular theory developed that the move was political. The FOMC has seen a few new members since September (remember it’s only 19 plots) and interest costs are rising fast for the Government that is keen maintain high deficits and like to do so at lower rates. Was it a White House Janet Yellen call to the Democrat-appointed doves for help?  Probably not. Looking at the dots, even the most hawkish September estimates dropped significantly. This wasn’t a movement of a few individuals. Most of the Committee moved towards more rate cuts. This is probably NOT a political pre-election play. The Fed remains independent and, to the degree to which 19 economists and lawyers can agree on the colour of the sky, single-minded.

So what was it?

The Fed knows that if they say “three rate cuts”, markets will price in double that. Issuing that Dot Plot and against their own narrative of the previous months, suggests that they would be comfortable with it.

Yet in the next two days, Vice Chair Williams who speaks for the New York Banks and Boston Fed Chair Bostic, a dove, both came out with hawkish messages. The latter said that he would expect two cuts at the most, the former said that “we aren’t even discussing rate cuts right now”. Chicago Fed’s Chair Goolsbee, another dove, warned that it’s too early to call victory against inflation. Already three key officials have warned against rate bullishness. In the next week more could join them.

Yet, the Dot Plot suggested three rate cuts.

The Fed seems to be contradicting itself again.

But if we ignore the Dot Plot, inflation, Fed statements, growth rates, unemployment all suggest paced rate cuts. So far, the only outlier is the Dot Plot, an anonymous survey completely devoid of narrative, and this assuming that the FOMC was comfortable with unleashing market animal spirts.

Asking the wrong question

Even if the FOMC however, did, become more dovish, markets are still asking the wrong question. Three rate cuts in the last months of 2024 is not the same thing as three (or six) cuts starting in March. If the Fed wants to return to the usual conservative form, it will now specifically have to direct markets to think “late year” instead of Q1. If cuts indeed come near the end of the year, we should expect monetary and economic conditions to remain tight for the next few months. If they come early, then economic outlook will be materially revised upwards, and inflation risks will be augmented. In the next few days, we expect that more Fed officials will have to clarify their position. What is at stake here is no less than the reputation of the world’s de facto central bank.

What it all means for investors

As for risk assets? Risk is now elevated as bonds and stocks are priced to near-perfection. The Dow is at all-time highs and so is the German Dax. The S&P 500 is 100 or so points shy of its previous top. Bond markets have rallied very hard in the past month or so. And the Fed will likely try to curb the market’s enthusiasm going forward. The bullish move that started in early November will, at the very least, be met with resistance.

While our call for rate cuts in the latter part of H2 2024 is now even more uncertain (we had acknowledged it as a low-confidence call), our key risk, a rebound in inflation, becomes even more impactful. 

And the larger question is whether the Fed is being erratic. Whether its data-driven approach has reached its limits, as data itself becomes volatile.

Whatever the case, we think that if one positioned their portfolio for the next bull market, one should still have to be ready for heightened volatility, especially in the first months of 2024, as the inflation story may yet have more twists and turns.

George Lagarias, Chief Economist

Market Update

Last week, global equities returned +1.5% in GBP terms, as the dovish pivot of the Federal Reserve sparked a broad-based rally across asset classes. US equities returned +1.3%, while European equities also generated positive returns of +0.7%, despite the European Central Bank’s hawkish narrative and refusal to discuss imminent interest rate cuts. UK equities lagged, delivering a return of +0.3%, while Japanese equities and emerging market equities saw returns of +1.1% and +1.4% respectively.

Within commodities, gold prices rose +1.2% in local terms to $2032.3/oz, but US Dollar weakness ensured that gold prices remained flat in GBP terms. Oil, however, saw a slight decrease, returning -0.9%.

In the bond market, there was a substantial decline in yields. The US 10-year treasury yield decreased from 4.23% to 3.91%, a change of -32 basis points. The UK 10-year gilt yield mirrored this movement, decreasing –3bps to 3.78%.

Finally, in the currency market, Sterling appreciated by 1.21% versus the US Dollar as expectations of rate cuts by the Fed encouraged US Dollar weakness.

Macro news

UK GDP fell by 0.3% in October, following growth of 0.2% in September. The main contributor to the fall was services, which fell by 0.2%, driven by a slowdown in the information and communications sectors. Production output also fell by 0.8%, driven by a 1.1% contraction in the manufacturing sector. A decline was seen in 10 out of 13 manufacturing subsectors, with the largest negative contributions coming from a 2.5% fall in the manufacturing of computer, electronic and optimal products and a 3% fall in the manufacture of machinery and equipment not classified in other sectors.

The Bank of England, European Central Bank and Federal Reserve all kept interest rates steady in their respective monetary policy meetings last week. While the result was exactly as expected, of particular interest was the Federal Reserve’s revised ‘dotplot’, which showed that most officials expected there to be rate cuts in 2024. Markets also welcomed Jerome Powell’s statement that the benchmark rate was now “likely at or near its peak for this tightening cycle”.

The week ahead

UK investors will be paying attention to the UK’s inflation rate and retail sales data, which come out on Wednesday and Friday respectively. From the US, the Personal Income and Outlays report will come out on Friday, which includes data on consumer income and spending as well as core PCE, the Federal Reserve’s preferred measure of inflation.