The 2024 Financial Landscape Is All About the Fed

As investors look ahead to the year ahead, one thing is abundantly clear: What’s on their minds is whether the Federal Reserve is done raising interest rates and will lower them next year. next year. Although interest rate expectations still matter, fluctuations in financial markets – stocks, bonds and the dollar – over the past two years have been dominated by expectations for action by the Federal Reserve.

The first chart shows that there has been a close correlation between 10-year Treasury yields and the trade-weighted dollar index during this period. Bonds sold off (yields rose) and the dollar rallied as investors thought the Fed would raise rates. Conversely, yields fell and the dollar weakened as investors anticipated the end of Fed tightening.

The second chart shows that the stock and bond markets have also moved in tandem for most of this period. (Note: the right axis of bond yields is inverted for ease of comparison). Before June of this year, both markets experienced sell-offs when the Fed was expected to raise interest rates, and they recovered when investors thought the Fed was finished tightening. interest rate.

The two markets diverged in the third quarter, however, when real GDP growth turned out to be much stronger than expected. This led bond investors to to give up that the Fed would cut rates and 10-year Treasury yields hit a 15-year high of 5%. The stock market nevertheless rose, as stock investors were reassured by the reduced risk of recession.

More recently, bond and stock markets have seen a significant recovery amid favorable inflation and signs of a slowdown in the labor market. The bond market is now in that the Fed will lower the funds rate by 75 to 100 basis points next year starting in the spring, and stock investors seem to agree with that assessment.

The main problem with jumping on the bandwagon, however, is that investors have been wrong to anticipate Fed policy over the past two years.

According to a Deutsche Bank research report cited in Markets Insider (Nov. 17), the U.S. stock market incorrectly priced in a Fed pivot six times during this period. Economists at Deutsche Bank warn that while Fed rate cuts are possible next year, the final step in bringing inflation back to the Fed’s 2% target rate tends to be the most difficult. Indeed, Fed officials have indicated they are not ready to declare that the fight against inflation is over, and they warn that there could be further tightening if economic data warrants it.

So, with these considerations in mind, how should investors position themselves?

My view is that two main considerations will influence the Fed’s rate decision.

The first consideration is that Fed officials want to ensure that core inflation, which excludes the volatile food and energy components, is on track to approach its average annual target of 2%. This is a necessary condition for the Fed to leave its rates unchanged.

That doesn’t mean the policy rate needs to hit precisely 2%, but Fed officials would likely need to see the rate fall below 3% to be convinced they are within reach of their goal. THE The latest projections from the Fed in September, this outcome is possible, with a median forecast for core PCE inflation of 2.6% in 2024 and 2.3% in 2025. Even if Fed policymakers are reluctant to declare that the fight against inflation is over, they could adopt a neutral position. Before a long time.

The second consideration is that for the Fed to ease monetary policy, it must be convinced that the economy is weakening. The key indicator it will use to make this assessment is whether there are signs of labor market underutilization.

What is striking about the Fed’s assessment, in this regard, is that the latest projections do not indicate that Fed officials are particularly worried about rising unemployment or a recession. Indeed, the unemployment rate is expected to remain around 4.0% to 4.1% until 2026, while the economy is expected to grow close to its potential rate of 1.8%.

This is where the Fed’s forecasts are most likely to be wrong. Although the economy has been remarkably resilient so far in the face of Fed tightening, the economy is showing some signs of cracks. The most egregious is the housing market, where the combination of rising home prices and 30-year mortgage rates hovering around 7.5% has made housing unaffordable for many potential buyers. The manufacturing sector is also weak due to higher interest rates and a strong dollar. And consumption fundamentals show some deterioration as household savings in low- and middle-income groups erode.

Under these circumstances, labor market conditions are expected to continue to moderate and the unemployment rate is likely to increase in the coming year. If unemployment were to reach 4.5% or higher, I think the groundwork would be laid for the Fed to cut rates, as this would indicate that there is a slowdown in the economy which would reduce the risk of a resurgence of inflation.

The extent of the Fed’s easing would ultimately depend on whether there is a recession. This remains a difficult situation because there is typically a year or more between the end of Fed tightening and the start of the recession.

Overall, my conclusion is that bond investors may finally be right to anticipate rate cuts next year and more to come in 2025. However, the extent of the Fed’s easing will depend on how concerned it is facing a possible recession and the instability of financial markets.