At their late January meeting, the Federal Reserve Open Market Committee kept the Fed funds range unchanged at 5.25-5.50%, where it’s been since last July. There were no dissents, even as the voting membership evolved to a new group for the year.
The formal statement language was updated significantly. Economic growth was noted as still “expanding at a solid pace,” job gains remaining “strong,” with inflation having eased but remaining elevated. References to the U.S. banking system and tight financial conditions were removed, replaced by employment and inflation goals “moving into better balance.” References to further firming in policy were removed, which was significant. Most importantly (and negatively for market response afterward), the FOMC “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.”
Based on CME Fed funds futures markets, the probability of no action was about 95%. By March, odds of a quarter-percent cut have risen to 55%. For June, the chances of three rate cuts rise to 50%, with the next highest odds at two cuts. The furthest-out available estimate, December 2024, shows the highest probability hovering around 4.00% (5-6 cuts). The Fed’s ‘dot plot’ from last month implied the year-end rate at an average of about 4.75%, showing fewer anticipated cuts—the difference between the market and Fed is the source of the current debate.
The rally in stock and bond markets in Q4 last year was driven by hopes of sooner-than-expected rate cuts by the Fed and other central banks. By contrast, the message received by markets in recent weeks was more tempered in terms of rate cuts likely to come later and/or to a lesser extent than expected (especially in response to continued strength in U.S. economic data). The Fed seems to be in a continual verbal battle of overshoot and undershoot—and finetuning the message back to a more moderate path. The Fed’s insistence on high transparency in communications in recent years has resulted in investors parsing apart every word from every Fed formal communication and informal speech. Aside from all this, it leads to the possibility that early 2024 sentiment could continue to be driven by this back-and-forth in rate expectations. Another question regarding the depth of any cuts is the reason behind them: (1) normalization, reflecting slowing inflation conditions not needing the same degree of tight policy, implying gradual changes, drawn out over time; or (2) recession, requiring more rate cuts at a faster pace (several percent, based on the average recession).
Economy. For Q4-2023, the U.S. economy grew at an initial estimate of 3.3%, slower than the exceptionally strong Q3, but still surpassing expectations. The Atlanta Fed’s GDPNow tool predicts growth to remain robust for Q1-2024 but decelerating to 3.0%. The economy continues to run at a far more rapid clip than expected last year, when the narrative was all about recession. Now, the base case has switched overwhelmingly to ‘soft landing,’ despite a variety of leading indicators still pointing to eventual slowing.
Inflation. This focus of Fed concerns remains elevated, with December trailing 12-month CPI having come in at 3.4% and 3.9% for headline and core (ex-food and energy), respectively. More specifically for the Fed’s preferred inflation basket, core PCE has decelerated to annualized rates of 1.9% (past 6 mo.) and 1.5% (past 3 mo.)—both now below the Fed’s 2% target. The good news is that inflation has been fading from being the single primary story markets are focused on. Upside risks remain, though, with one being higher transportation costs due to conflict in the Red Sea—a key global shipping lane for goods and especially energy. The Fed remains cognizant of potential inflation pressures, as a less desired outcome would be a cut in rates followed by a hike of some sort, and the market confusion that might result.
Employment. Labor continues to be another bright spot of the economy, with the unemployment rate at a steady 3.7% for December. However, some peripheral employment data, such as openings, have flattened out, with further weakening in some industries. Looking at official data, labor hasn’t yet weakened to the point that the Fed would likely consider easing in response to this alone, with 2024 possibly providing further clarity on this slowing path.
Another item not talked about widely yet, but a behind-the-scenes important policy change, is the potential tweak to quantitative tightening (QT) in the coming year, shown as a discussion item in the December FOMC minutes. Since summer 2022, QT has involved the runoff (allowing maturity without reinvesting proceeds) of U.S. Treasuries by $60 bil./mo. and U.S. agency mortgage-backed securities by $35 bil./mo. This effort was designed to unwind the extreme bond-buying under the prior regime (quantitative easing, ‘QE’), during which the Fed purchased bonds, pulling them out of the market, reducing supply, and intended to raise prices and lower yields. The most notable effects were on the long-term part of the yield curve not as closely tied to short-term Fed funds actions. The current QT process allows the Fed to normalize/shrink its immense balance sheet—which has already fallen by a few trillion from its $9 tril. peak size—although it will likely remain a few trillion in size, for financial stability and liquidity reasons. As implied by the name, QT has a tightening effect on policy, which, if the Fed begins easing short-term rates, would create a contradiction of sorts. But, slowing down the run-off of bonds should lessen that tightening impact, as would stopping QT altogether. There are also subtle distinctions possible, including slowing the run-off pace of U.S. Treasury debt, but allowing their U.S. agency mortgage-backed security holdings to continue to run off at a faster rate. This is in line with the Fed’s goals of wanting to unload MBS from their balance sheet in favor of an all-Treasury portfolio, back to its core monetary policy objectives. However, the byproduct could be a lessened government ‘cap’ on consumer mortgage rates, which obviously spiked over the past two years and still pressure home affordability. Overall, QT was expected to decrease market liquidity (via less Fed buying), but that hasn’t happened to the degree feared at this point.
As important as nominal interest rates are, they can be broken out into two components: inflation and the ‘real’ interest rate. The two inputs can differ dramatically, based on the inflation basket and trailing timeline used, but real rates are now more solidly in the positive for the first time in years. While a very attractive feature for bond investors, higher real rates also have a tightening effect on the economy that may ultimately slow growth the longer they persist. The positive news for stock, bond, and real estate markets is that the peak in policy rates for this cycle is likely behind us (reducing a significant headwind to growth and valuations). Absent a deeper recession, where conditions can take longer to repair, lower yields have created a positive tailwind historically, regardless of the reason for the easing.
Ryan M. Long, CFA
Director of Investments
FocusPoint Solutions, Inc.
Sources: CME Group, Federal Reserve Bank, U.S. Bureau of Economic Analysis, U.S. Bureau of Labor Statistics, FocusPoint Solutions calculations.
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Sources: Ryan M. Long, CFA; Director of Investments; FocusPoint Solutions, Inc.
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