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Moments of clear agreement in markets are rare and usually fleeting. However, one came this week as weak US inflation data convinced investors that the Federal Reserve will not raise interest rates in December.
Any consensus on the outlook for the final weeks of a rollercoaster year is a real relief. Investors can enjoy it – while it lasts. Inflation figures on Tuesday painted a better-than-expected picture, with the core rate falling to a two-year low of 4 percent in October.
Analysts joked that they could now plan Christmas parties for the week of the Fed meeting in mid-December. Markets were immediately buoyant, with the S&P 500 having its best day in more than six months, while two-year Treasury yields fell nearly 0.25 percentage points.
Just two weeks ago, futures markets reflected expectations that the probability of a higher interest rate by the end of the year was one-third. Now the market is pricing in a 100 percent chance that interest rates will remain in the current target range of between 5.25 percent and 5.5 percent at the Fed’s policy meeting next month, according to the CME’s FedWatch tool.
Why so sure if we’ve been here before? According to analysts at Deutsche Bank, this is the seventh time this interest rate cycle alone that investors have expected the Federal Reserve to take a more dovish stance.
The most recent incident, in March, was linked to fears that turmoil in the US banking sector would spread, and before that, in September last year, to fears that problems in the UK government bond market would have wider implications.
Three previous bouts in 2022 when interest rate hikes began were the result of concerns that the U.S. economy was not strong enough to handle tighter monetary conditions, particularly with the start of war in Ukraine.
In most cases where investors bet that interest rates had peaked, stocks rallied sharply on hopes that more favorable conditions would spur growth. On this occasion, several softer data have helped to support the notion that the tipping point has indeed been reached this time.
U.S. unemployment has risen to 3.9 percent, retail sales growth has slowed and manufacturing surveys are weakening. All of this should help convince the Fed that the economy is getting out of hand. Just over two weeks ago, Fed Chairman Jay Powell himself described the central bank’s stance as a “cautious approach” “given the uncertainties and risks and how far we have come.”
The danger for investors, however, is that the markets can no longer take a break and expect rapid interest rate cuts. The CME’s FedWatch tool estimates there is a two-thirds chance that rates will be a full percentage point lower by the end of next year, with the first cut coming as early as June.
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It could well be that the futures markets actually reflect very divided views – with some investors believing that the fight against inflation will require the Fed to keep interest rates higher for longer, while others are betting that this will be the full effect of the What will result in the harshest cycle of interest rate hikes in modern history will soon cause the economy and interest rates to fall significantly.
That would explain why fund managers currently have the largest overweight in bonds since the 2008 financial crisis, as revealed in Bank of America’s monthly survey this week. Bondholders benefit from high yields and price gains when interest rates fall, dragging down yields with them.
There is also an expectation that the Fed will cut interest rates quickly when things get going. In 2019, it held the peak of 2.25 percent for just seven months before declining. Before the 2008 crisis, interest rates peaked at 5.25 percent for an unusually long 15 months before being cut sharply as unrest spread.
But what if the coming years are less like the pattern of peaks and sharp declines that has been common in the recent past and more like the mid-1990s? Then a rapid series of rate hikes in 1994 caused the Fed’s target to rise from 3 percent to 6 percent by early 1995. Only three cautious quarter-point cuts followed before another increase in 1997. This pattern repeated itself until the dot-com bubble burst in 2001.
“We feel like the 1990s are actually a pretty good template for this [the Fed] could be enough. They could move up and down a little bit as they reconsider how restrictive their policies are,” said Marc Giannoni, chief U.S. economist at Barclays, which forecasts a single Fed rate cut in 2024. “When the economy is weakening but inflation is stagnating at, say, 3 percent or more. I don’t believe [the Fed] will be able to ease monetary policy.”
This uncertainty is not good for the stock and debt markets, aside from the enthusiasm seen this week. “Everyone is desperate for a rally, but the rise in stocks and bonds means we have eased financial conditions again and made the Fed’s job harder,” said Julian Brigden, co-founder and head of research at MI2 Partners. “We still have low unemployment. To contain inflation, we need lower nominal growth – and tougher conditions to achieve it.”
Powell’s August description of the Fed as relying on the stars when skies are cloudy drew some ridicule at the time, but it’s worth keeping in mind when faced with another round of bullish interest rate predictions from markets.
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