Investors finally got the pivot they had been waiting for in December: As economic releases continued to point to disinflationary pressures alongside a solid labor market, the Federal Reserve reacted by increasing the number of rate cuts they expected in 2024, though the market still expects more cuts than the Fed is forecasting. Most asset classes rallied strongly, with financial conditions easing significantly.
• The FOMC held the fed funds target rate at a range of 5.25%-5.50%, with the median FOMC official indicating they expected three rate cuts in 2024.
• 199k jobs were added in November, while the prior two months saw net revisions of -35k.
• December consumer confidence rose sharply according to both the University of Michigan’s Survey of Consumers (69.7 versus the prior 61.3) and Conference Board’s Consumer Confidence Index (110.7 versus the prior 101.0).
• Retail sales grew 0.3% in November, against expectations for a decline of 0.1%.
• Housing starts surged 14.8% in November compared to expectations for a 0.9% decline.
• Most major currencies appreciated against the U.S. dollar in December. Gold also saw gains, boosted by notable declines in Treasury yields.
• Bottom-up 2024 EPS estimates for the S&P 500 moved down to $244 in December from $246 previously, while top-down strategist estimates were revised up to $240 from $238.
• Small-cap stocks outperformed large-cap stocks by 7.3 percentage points, the largest differential in monthly performance since December 2000.
• Energy was the only sector with negative returns in December, as the 5.7% decline in oil prices offset a broader uplift in stocks.
• Buoyed by the decline in long-term Treasury yields, Real Estate was the best performing sector for the first time since April 2021.
• 10-year Treasury yields declined by 45bps in December, and 105bps in November and December combined, the largest two-month decline since December 2008.
• The total investment grade U.S. bond market had its second-best month since the 1980s, only outpaced by the prior month.
• The average maturity of IG bonds rose to 10.8 in December, as the decline in yields spurred corporations to refinance debts and push maturities out.
• HY bond spreads narrowed to 371bps, the tightest since April 2022.
What’s A Few Cuts Between Friends?
It was December 13, with the Fed set to announce their interest rate policy decision and release their Summary of Economic Projections (SEP). The labor and inflation reports leading up to the Fed meeting showed the job market remained strong and favorable downward trends in inflation continued. Pre-meeting, market participants expected four or five cuts in 2024, so when the Fed released its dot plot showing the median official expected three rate cuts, investor expectations must have taken a step back, right?
Wrong. Investors boosted their predictions to expect even more rate cuts than they did before. It seems like the exact numbers themselves didn’t matter much, with investors instead focusing on the trajectory of Fed opinion: The central bank reduced its 2023 rate forecast by 25 bps and increased the number of cuts they expect in 2024 from two to three. What’s a few rate cuts between friends anyway?
It’s also interesting to note that the market has consistently priced in lower interest rates than the median Fed official’s projection, before eventually coming around to their view. Call it déjà vu, call it not learning your lesson, but investors are facing the risk that the Fed’s projection is closer to the eventual path of interest rates than their expectations are.
Fighting the Last War, or the Next?
A common refrain for market watchers is “don’t fight the Fed”. Yet investors often can’t resist, with the recent loosening of financial conditions a good case in point: Treasury yields fell significantly as the market priced in more rate cuts, and both stocks and bonds rallied. Broadly speaking, investors are behaving as if the fight against inflation has already been won, while the Fed remains unconvinced. In a sense, the market thinks the Fed is focused on the past and behind the curve, but what if the Fed isn’t focused on the last battle, but the next one?
There’s been a lot of crying over spilled milk when it comes to how much of the disinflation we’ve seen being due to the Fed’s rate hikes versus pandemic-era supply shocks just finally healing. But where it’s undeniable that monetary policy had an impact is in the housing market. Home sales and prices, mortgage rates, and even household durable goods demand have all flattened in the higher interest rate environment. However, it has historically taken about a year for home price trends to reflect in the shelter component of the CPI. So while the market may be thinking about the disinflation we’re likely to see in the next few months, the Fed may already have its eyes on what’s needed to ensure not only that inflation will decline to 2%, but that it will stay there.
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