The three things I would tell my clients this morning
Markets consistently underestimate the Fed’s willingness to fight inflation.
That’s why, when last week the Fed raised its rate forecast for 2024, both equities and bonds retrenched significantly.
Investors should position as best as they can for both the good scenario (rate cuts into 2024) or the bad scenario (no rate cuts before early 2025).
How long is “higher for longer”?
A consistent element of this rate hike cycle has been the differential between market optimism and Fed intentions. Since early 2022, markets were never really convinced about how far the Fed was willing to take things. Expectations have consistently fallen short of reality in terms of rate hikes.
One can’t really blame traders for this of course. Most came up during the 14-year quantitative easing period. A zero-rate and unlimited quantities of free money, the scenario they once took as their base. The place where, for some, the Fed might well mean revert one day.
It will take time for the idea of higher rates and a normal yield curve to sink in.
Meanwhile, markets were again surprised last week. The US Federal Reserve maintained interest rates but what rattled markets was the the “median dot”, the Fed’s official projection for where interest rates will be this time next year, went from 4.6% to 5.25%. i.e. The Fed forecasted no rate cuts in 2024, a sharp contrast with markets who, up until two weeks ago believed that the Fed would perform five rate cuts until January 2025, starting as early as May 2024.
This caused the S&P to retrench nearly 3% for the week and the 10y Treasury yield to climb to 4.46%, its highest level since 2007. But still, markets forecast three rate cuts next year, starting from July.
So, at this point, further rate hikes have been substituted with “higher for longer”. How longer can “higher” be?
Between 1994 and 2001 the Fed kept rates above 5% consistently. In 2007, the top rate was kept for 15 months. Average inflation for the period was 2.6%, exactly where economist surveyed by Bloomberg expect average inflation to be over 2024. After that, inflation is presently expected to go down only slightly, to 2.3%, which could possibly allow for some early rate cuts.
However, the truth is that inflation expectations change every day. The “data-dependent” message of central banks is another way of saying “we don’t know where inflation is headed”.
So, investors should position as best as they can for both the good scenario (rate cuts into 2024) or the bad scenario (no rate cuts before early 2025).