Why stock market investors continue to be at the mercy of changes in interest rate cut expectations

All of this together provides a glimpse of what the year ahead will hold for investors. Already, the so-called “January effect” – the theory that stock prices tend to rise more than in other months – could be tested by headwinds such as stagnant inflation. The downward trend in inflation in recent months has given traders and investors hope that the Federal Reserve could cut interest rates by as much as 6-7 percentage points between March and 2024. I was holding her.

But within the first few days of the new year, reality began to sink in. First, multiple interest rate cuts tend to be associated with a recession rather than a soft economic landing.

Additionally, Mike Sanders, head of fixed income at Wisconsin-based Madison Investments, which manages financial products, said the idea that the Fed could cut interest rates the way traders envisioned it meant that policymakers were trying to avoid inflation. The chances of losing the battle will be greatly increased. Assets are $23 billion. The reason is that six or more interest rate cuts would ease financial conditions too much, raising the risk of a return to inflation that would force officials to raise rates again, he said.

Minutes from the Fed’s Dec. 12-13 meeting show policymakers are uncertain about the outlook for rate cuts this year and have not ruled out further rate hikes. Nevertheless, federal funds futures traders remain clinging to expectations that borrowing costs will fall significantly, with rates now expected to be cut by five to six quarter points by the end of the year, totaling 125 to 150 basis points of relief. This is seen as the most likely option. That’s roughly double what policymakers agreed to last month when they voted to keep interest rates at a 22-year high of 5.25% to 5.5%.

Uncertainty over the fate of U.S. interest rates could disappoint investors again, dampening optimism that saw all three major stock indexes post their best annual performance in two to three years in 2023 . In November, analysts at Deutsche Bank AG DB
+0.81%
There have been seven times since 2021 when markets expected the Fed to take a dovish turn, but they were wrong.

Financial markets have been operating with “very high expectations” for a rate cut in 2024, but the only way to substantiate six rate cuts this year is with a “sudden and sharp recession in the economy,” the managing director said. said Todd Thompson, portfolio co-founder. He is the manager of Reams Asset Management in Indianapolis, where he manages $27 billion.

Heading into 2024, euphoria over the prospect of lower borrowing costs has triggered what Thompson calls “an alarming rally in everything,” leaving stocks and high-yield corporate bonds vulnerable to declines between now and the next six months. He says there is. But beyond that period, “the trend is likely to be lower interest rates as inflation continues to recede while the economy finally tightens.”

Next week will bring the next major US inflation update, with December’s Consumer Price Index report on Thursday. The annual headline inflation rate according to the CPI slowed to 3.1% in November from a peak of 9.1% in June 2022. Additionally, the core interest rate measured by the Fed’s favorite inflation measure known as PCE fell to 3.2% annually. The year-on-year rate rose in November from 4.2% in July.

Citing uncertainty over how inflation is most likely to move forward, Sanders said the Fed needs to keep interest rates high and that the U.S. labor market is “up from March in the first quarter.” “It will not deteriorate quickly enough to justify an initial rate cut.” Madison Investments.

Expectations for rate cuts “are going to be an issue in 2024, and a lot of that will revolve around getting inflation back to the 2% target,” Sanders said on the phone. “We think a rate cut of between 75 basis points and 125 basis points makes sense, and we think the first move will be more of a June-like event. The labor market doesn’t fall off a cliff. As far as this goes, I think the March interest rate cut is meaningless.

History shows that Treasury yields tend to fall in the months leading up to the first rate cut in the Fed’s easing cycle. But that’s not happening now. Government bond yields have been on an upward trend since the end of December, 2- BX:TMUBMUSD02Y,
10- BX:TMUBMUSD10Y,
The 30-year Treasury yield BX:TMUBMUSD30Y ended Friday at its highest level in more than two to three weeks.

See also: What history tells us about the stock and bond markets ahead of the Fed’s first interest rate cut

Financial markets generally tend to process information efficiently, but this time they “were not very accurate in terms of pricing in rate cuts,” said Lawrence Gillum, chief fixed income strategist at the Charlotte, North Carolina-based brokerage. Stated. LPL Financial dealer. He said the big risk in 2024 is if financial conditions become too accommodative and the Fed declares victory over inflation too soon, in which case prices will decline in a manner reminiscent of the 1970s under former Fed Chairman Arthur Burns. He said the pressure could flare up again.

“We think rate cut expectations have moved too quickly, and the support we’re seeing for yields now is the market recognizing that rate cuts may not be as aggressive as they’re priced in,” Gillum said. ” Gillum said. phone.

The December CPI report, released on Thursday, will be the data highlight for next week.

Consumer credit statistics for November will be released on Monday, followed by trade deficit statistics for the month the following day.

On Wednesday, the November wholesale inventory report and New York Fed President Williams’ remarks will be released.

The first weekly unemployment claims numbers will be released on Thursday. The producer price index for December will be released on Friday.