- No change in interest rates expected from US central bank on Wednesday
- Only three rate cuts now expected in 2024, down from the six expected in January
- First cut seen coming in June, not March as originally thought
- Fed may tinker with Quantitative Tightening
“Just as the Bank of Japan finally gets around to raising interest rates, investors are still hoping that the US Federal Reserve will cut them, although the first reduction is now seen coming in June and not at the latest meeting in March, as markets had thought at the start of the year,” says AJ Bell investment director Russ Mould. “Chair Jay Powell and his colleagues on the Federal Open Markets Committee are therefore moving more slowly than markets had expected and the consensus forecast now is the Fed will cut rates just three times to 4.75% by year end, rather than six times, and that is because US inflation is proving more resilient, and inflation stickier, than expected.
“This recalibration of expectations is not guaranteed to derail the equity bull market, even if 2024 could be the third year in a row when interest rate expectations have proven way off beam.
“The consensus view in 2022 was that a recession was coming – and that proved to be wrong.
“The consensus view in 2023 was that inflation would cool and rate cuts would come quickly – and that proved to be wrong, as markets are still waiting for the first move from the Fed (and the Bank of England and the European Central Bank, for that matter).
“For 2024, markets are betting on a cooling in inflation, a soft economic landing (or even no landing at all) and a pivot to rate cuts from central banks after two years of quick-fire increases.
Source: www.cbrates.com
“The markets’ misjudgement of 2022 laid the groundwork for a big rally in global equities in 2023 and their inaccurate analysis of 2023 did no damage either, as the Germany’s DAX, France’s CAC-40, Japan’s Nikkei-225 and Australia’s ASX-200 all barrelled to new peaks, alongside America’s headline indices, the Dow Jones Industrials, the S&P 500 and the NASDAQ.
“But at the very least investors might like to consider the possible implications of a rather unfortunate hat-trick of poor forecasts in 2024, not least because three recent sets of data could just challenge that cosy consensus of cooler inflation, a shallow downturn (at worst) and lower rates, a combination that is widely expected to propel US share prices onwards and upwards.
“The first is the Biden administration’s planned Budget for 2025. Despite a slew of proposed tax increases to provide additional funding, including a hike in corporation tax to 28% from 21%, the $7.3 trillion spending plan still leaves a $1.8 trillion annual deficit, the third highest ever. That increased funding need means more US Treasuries will have to be sold and if the biggest buyer of the past few years – the US Federal Reserve, thanks to Quantitative Easing – is still a net seller, thanks to Quantitative Tightening, then yields may need to stay higher than expected to tempt would-be buyers.
Source: LSEG Datastream data, FRED - US Federal Reserve database, Congressional Budget Office
“The second is how US inflation, as measured by the consumer price index, reaccelerated to 3.2% year-on-year.
“The third is how US factory gate, or producer price, inflation also sped up, to 1.6% year-on-year. This figure can be seen as an indication of what is coming down the pipe toward consumers in time, so while the lowly headline number is welcome, the increased pace of change is not.
Source: US Bureau of Economic Analysis, FRED - St. Louis Federal Reserve database, LSEG Datastream data
“Stock markets seem unconcerned – perhaps even welcoming the prospect of higher nominal GDP growth – but bond markets are paying attention. The iShares 20-year Plus Treasury Bond exchange-traded fund (ETF) is down by nearly 8% from its December high, as long-dated US Treasury yields go higher once more in a rout that is already wiping out two years’ worth of coupons at a stroke.
Source: LSEG Datastream data
“The yields on two-year and ten-year US Treasury bonds are creeping higher again and their prices sliding lower. This is in response to both the sticky inflation numbers but also, presumably, the prospect of increased bond issuance by the US government should President Biden win the election in November and get to implement his planned budget (and even if he does not prevail, the alternative, Donald Trump, is hardly known for being spendthrift).
Source: LSEG Datastream data
“Higher bond yields reflect a recalibration of expectations for interest rate cuts, for the second year in a row. At the start of 2024, the CME Fedwatch data service suggested markets were looking for six, one-quarter point rate cuts from the US Federal Reserve this year, with the first coming in March. Now consensus is for three cuts, starting in June, with the sixth cut of the lowering cycle only coming in September 2025.
Source: CME Fedwatch, US Federal Reserve, LSEG Datastream
“The biggest sign of how markets are reassessing sticky inflation is the US two-year Treasury yield. This traditionally moves six to nine months before the Federal Reserve acts. The two-year currently yields 4.73%, as if to suggest that three rate cuts is all the markets are going to get in the next 24 months and that hopes for six in eighteen are still optimistic.
“Again, this is not certain to derail the bull run in equities, especially if higher nominal GDP growth (and prices) help to boost corporate profits. But just as weight stops trains and racehorses, higher-than-expected interest rates tend to slow down share prices in the end, especially across long-duration sectors such as technology and biotechnology, which is exactly where investor optimism is most prevalent at the moment.”
