2023-12-08 12:20:35 ET
Summary
- Despite Fed Chairman Jerome Powell's clear and consistent communication on keeping interest rates higher for longer, financial markets are simply not buying it.
- The S&P 500 Index is up 19.4% year-to-date, and bond yields have fallen meaningfully.
- Given the positive economic trends that we are seeing, we see a strong case for the equity bull market to continue.
- What is truly worrying and unpredictable for us, however, is policy mismanagement by the Fed.
- We believe that the Fed has reached a critical make-or-break moment to decide if it will nail that soft landing this time, or live up to its reputation of falling behind the curve.
- But one thing is clear. The financial markets are telling the FOMC to make its move now, or it may very well be too late again.
Monetary policy is more commonly described as a delicate balancing act rather than a scientific process. And public discourse over the subject matter often appears to be much more speculative and anecdotal, rather than technical. Indeed, some would have noticed that the Federal Reserve's (Fed) aim of achieving and maintaining an "appropriate level of interest rate" often resembles more like guesswork rather than the application of some well-understood economic model.
Despite the seemingly confident predictions that economists offer in the financial media (amateurs and Nobel laureates alike), the reality is that such predictions are rarely reliable enough to give investors a meaningful advantage at consistently beating the market. Even the Fed with its extensive research capabilities and access to economic data is renowned for its dismal track record at nailing soft landings. As the accompanying chart shows, the Fed has often been too late at easing monetary policy in the past, leading to economic recessions.
It is also not unusual for FOMC members to be at odds with each other over what they think is the appropriate path for the Fed funds rate. This adds to the confusion over what is an appropriate stance for monetary policy in the short term.
Historical experience certainly suggests that monetary policy is much more complex and sophisticated than many observers perceive. Perhaps this is why debates on monetary policy frequently degrade into speculative chatter and unsubstantiated claims such as "yield curve inversion means recession" or "the Fed is surely going to mess up again" . When economic models fail to adequately explain or manage complex problems, speculative ideas become the next best alternative for market participants. As a consequence, speculative behavior ends up becoming the dominant driving force in the bond markets. Otherwise, how do we explain the wild swings in treasury yields that we have witnessed in recent months?
Speculative Optimism Or Market Wisdom
Despite Fed Chairman Jerome Powell's clear and consistent communication on keeping interest rates "higher for longer" and insisting that "the committee is not thinking about rate cuts right now at all" , financial markets are simply not buying it. Amusingly, even the FOMC's median forecasts for the Fed funds rate show that members on aggregate are expecting rate cuts to come in 2024.
It should not come as a surprise that equity markets have surged on the back of the increasing likelihood of a soft landing. The S&P 500 Index ( SPX ) is up 19.4% year-to-date, and the initially narrow rally is beginning to show signs of broadening beyond big technology and AI themes.
Since October 2022, we have been expressing our bullish view on equities given increasing evidence that inflation is on track to hitting the Fed's 2% target by the end of 2023. The latest data published by the Bureau of Economic Analysis showed that the U.S. personal consumption expenditures price index, excluding food and energy prices, rose by 0.2% in October and 3.5% year-on-year. Meanwhile, we are also seeing the labor market come through with declining job openings and higher jobless claims in October.
Bloomberg
Bond markets are pricing in expectations for rate cuts in 2024 with yields across the curve having peaked in October and falling meaningfully since. This is in line with major investment banks recently upgrading their outlooks for 2024. Morgan Stanley, UBS, and Goldman Sachs are all expecting the Fed to cut rates in 2024. UBS is among the most aggressive by penciling in as much as 275 basis points of rate cuts by the end of 2024 and expecting the first cut to come as early as March.
TradingView.com TradingView.com
Taken together, the market consensus has quite clearly shifted in favor of monetary policy normalization and a constructive view on equities in 2024. Given the positive economic trends that we are seeing, we think the financial markets are rationally optimistic rather than speculative. Although speculation will always influence financial markets to a certain extent, we are comfortable to see the rally in equities being accompanied by improving macroeconomic fundamentals. After all, many of the risk scenarios that were flagged by the doomsayers, including stagflation, a contagion of bank failures, a property market crash, and a plunge in corporate earnings, have turned out to be quite manageable.
Therefore, we see a strong case for the equity bull market to continue. What is truly worrying and unpredictable for us, however, is potential policy mismanagement by the Fed.
Ignoring The Fed Speak
In an earlier article , we highlighted the Fed's challenging task of executing monetary policy while having to manage market expectations through carefully worded "Fed Speak". This essentially means that the FOMC may say one thing, and do another. If the FOMC declares the end of monetary tightening prematurely, financial conditions could ease rapidly, undermining the impact of rate hikes aimed at cooling the economy and taming inflation. On the other hand, if the market believes that the FOMC is late at taking its foot off the brakes, the market could crash in anticipation of a hard landing.
Therefore, it makes sense that Jerome Powell's carefully crafted comments were aimed at downplaying any expectations of rate cuts. For now, the FOMC has to pretend it is hawkish even if it thinks that rate cuts in 2024 are appropriate.
The problem, however, is that Fed Speak has clearly lost much of its influence on financial markets over the years. Investors with greatly improved access to high-quality macroeconomic data and analysis today have become much more sophisticated than before. Besides, more money is being managed by passive exchange-traded funds (ETFs) and institutional investors today than ever before. These forces could only mean that financial markets are becoming smarter and more efficient at pricing economic risks over time.
The Fed Can Learn From Its Mistakes
Make no mistake, however. Even if Fed Speak has become less relevant for financial markets, monetary policy remains one of the most impactful levers available to policymakers when it comes to steering the economy.
The Fed still suffers from the burden of its past mistakes for being too late at cutting rates, and the FOMC surely realizes that, in my view. And investors are right to worry that the FOMC risks making the same old mistakes again. However, we think it would be wrong to assume that the fate of policy mismanagement is set in stone. The FOMC can and should independently decide what is the best policy path going forward.
We believe that the Fed has reached a critical make-or-break moment to decide if it will nail that soft landing this time, or live up to its dismal reputation of always being behind the curve. But one thing is clear. The financial markets are telling the FOMC to make its move now, or it may very well be too late again.
For further details see:
Federal Reserve At Critical Make-Or-Break Moment