Is the Stock Market Too Optimistic About Rate Cuts?
It’s all about the Fed, again.
The stock and bond markets have both delivered powerful rallies in recent weeks. The move in stocks has been broad-based, with everything from small-cap stocks to mega-cap tech names performing well. Meanwhile, yields on the 10-year U.S. Treasury bond have sharply declined from near 5% levels in mid-October to sub 4% levels as I write (charts below).1
Bond prices have risen as yields have declined since October
And stocks have surged over the past two months
Nearly every expert investor, economist, or financial media pundit will tell you the rallies are tied to the Fed “pause” in interest rate increases, and also to the market’s increasingly dovish expectation for rate cuts in 2024. I’m not here to tell you these experts are wrong. But I do think investors should think about the market and economic outlook in a more nuanced way. Which is to say, remember that the Fed isn’t the only factor driving stock market trends.
Let me first be fair, though. Fed policy does matter. At the December 12-13 Federal Reserve meeting, officials voted unanimously to hold rates steady, as expected. But what came as a positive surprise was the decision to publish interest rate projections for the following year, which penciled in three quarter-point rate cuts. Markets rallied. The Fed also expressed fairly clearly that fighting inflation was no longer their sole mission, but that they were also focused on growth and employment. In Fed Chairman Jerome Powell’s words: “You’re getting now back to the point where both mandates [inflation and unemployment] are important,” adding that “We’ll be very much keeping that in mind as we make policy going forward.”
Following this meeting, the market seemed to be pricing in not only the possibility, but the probability of a soft economic landing with a continued downtrend in inflation—which are the conditions needed for the Fed to proceed with cuts.
But the questions investors need to be asking now are: What happens if the economy grows much more strongly than anticipated? Or what if inflation is a bit stickier than expected, due perhaps to a persistently strong labor market and rising wages and spending?
Recall that at the outset of 2023, nearly 100% of economists were calling for an economic recession. It never happened. Instead, the U.S. economy posted GDP growth of 2.2% in Q1, 2.1% in Q2, and a staggering 5.2% in Q3, while adding an average of 240,000 jobs per month. If pretty much everyone was wrong about the recession in 2023, it’s also possible the ‘herd mentality’ about rate cuts in 2024 is also misplaced. After all, Fed ‘dot plots’ in recent years have routinely been way off the mark.4
In other words, the market seems to be telling us that rate cuts are needed to sustain the rally. But I disagree.
I think inflation will slowly but surely continue in a downtrend, which should reaffirm the Fed’s stance on “pausing” rate increases. But I also think the economy could remain fundamentally stronger than most expect, which may also motivate the Fed to hold rates steady versus cutting too soon. In this latter outcome, the market technically won’t get what it wants (rate cuts), and short-term volatility may ensue. But the bottom line would be that the economy is fundamentally strong, which in the medium- to long-term is what will help drive earnings. And that’s what matters most.
Bottom Line for Investors
Markets are not ‘making up’ the possibility of rate cuts in 2024. Fed officials have indicated as much, with the median policy maker’s “dot” forecast for the benchmark Fed funds rate sitting at 4.6% (from the current 5.1%) by the end of next year.
The issue is that the Fed funds futures market is pricing in a 100% chance of rate cuts next year, which seems to indicate that there is way too much confidence in the Fed’s interest rate projections. As mentioned before, “dot” plot forecasts in recent years have been routinely wrong, sometimes by a lot.
If the market doesn’t get what it wants in terms of rate cuts, that could drive volatility. Investors should expect that. But at the end of the day, a strong fundamental economy and rising earnings matter far more than whether the Fed cuts rates two or three times in the new year. Becoming “Fed obsessed” is easy given all the attention the Fed gets, but investors should remember not to overlook the other critical data driving the investment decision-making process – growth, employment, and earnings.
Disclosure
2 Fred Economic Data. December 18, 2023. https://fred.stlouisfed.org/series/DGS10#
3 Fred Economic Data. December 19, 2023. https://fred.stlouisfed.org/series/DGS10#
4 Wall Street Journal. December 14, 2023. https://www.wsj.com/economy/central-banking/fed-fueled-rally-extends-gains-in-stocks-bonds-ec5e2139?mod=economy_lead_pos5
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