Don't Discount The Possibility That We See ZERO Rate Cuts In 2024
Why would the Fed take its foot off the pedal and risk inflation heating back up when there’s essentially no economic slowdown to speak of? The answer is there’s no good reason.
For better or worse, investors have been an optimistic bunch!
When stocks and bonds were tumbling in 2022, the only real rallies came when investors got hopeful that the Fed was going to pivot despite no evidence that they were ready to do so.
In 2023, the U.S. markets staged a huge 4th quarter rally in both stocks and bonds in anticipation of the Fed ending its 18-months long rate hiking cycle.
In December of last year, after Powell said that the Fed was expecting three rate cuts in 2024, the markets immediately moved to price in six. This is despite GDP growth coming in at 3% annually, the unemployment rate still sitting below 4% and inflation continuing to normalize. In other words, pretty much the opposite of the kind of conditions that would warrant a massive monetary easing cycle.
Investors have gotten so used to excessive tech stock valuations and unlimited monetary support from the government that their only question is “why can’t we get more of it?”
Investors Are Starting To Get Walked Back
Peak enthusiasm was reached about a month ago. That’s when the futures market priced in nearly a 90% chance of AT LEAST six rate cuts in 2024. On January 12th, there was even, according to the Fed Funds futures market, a 1-in-5 chance of 8+ rate cuts this year! Again, this despite the fact that the Fed had said to expect just three over the next 12 months.
Not surprisingly, just about every economic report and piece of data since then has supported the idea of “higher for longer” interest rates. Not that I want to get into the business of defending the Fed and its ability to see the future, but the one thing it has been consistent on over the past couple years has been its messaging. Powell repeatedly said that the Fed was going to continue to be restrictive on monetary policy conditions and he’s mostly followed through on that.
If you look at a chart of the S&P 500 in 2022, Powell was the reason that every mid-year rally got turned back. You can doubt their wisdom, but it’s also unwise to fight the Fed.
None Of The Latest Economic Data Suggests Rate Cuts Are Coming Anytime Soon
Since the Fed’s December meeting, we’ve gotten the following numbers…
4th quarter GDP - shows the U.S. economy growing by 3.1% year-over-year.
December retail sales - up 0.6% for the month and up 5.6% year-over-year.
January average hourly earnings - up 4.5% year-over-year.
Non-farm payrolls - job growth of 333K in December and 353K in January.
January unemployment rate - 3.7%, the 24th consecutive month it’s been under 4%.
January inflation rate - headline = 3.1%, core = 3.9%.
Tell me exactly which, if any, of those numbers suggests the need for easing monetary conditions any soon.
The U.S. economy is still humming. The soft landing has now become a very possible outcome in 2024. Inflation is still well above the Fed’s 2% target and trending more sideways than down. Wage growth is still hot. The labor market is tight.
Why would the Fed take its foot off the pedal and risk inflation heating back up when there’s essentially no economic slowdown to speak of? The answer is there’s no good reason.
Powell’s assertion that three rate cuts are warranted to start the normalization process following the run-up to 9% inflation is reasonable and defensible. The idea that the Fed needs to launch some massive rate cutting spree….
Investors Are Realizing That Massive Rate Cuts Aren’t Coming
Investors are finally starting to get the picture. A month ago, the markets were pricing in 6-7 rate cuts in 2024. Today, that number is down to 4. Still a little optimistic given the Fed’s forecast, but much more reasonable than before.
The bond market has also reacted. The 10-year yield got down to the 3.8% level at its low and just recently moved above 4.3%. That’s the equivalent of going from a 6 rate cut expectation to a 4 rate cut one, so long-term yields have adjusted appropriately.
Short-term Treasury yields, however, never really budged. Granted, they tend to move more right at the point that policy rates are changed, but the fact that they moved very little even as the markets were pricing in more rate cuts shows that the bond market was never really thinking it was a likely outcome in the first place.
Are We Headed Towards ZERO Rate Cuts In 2024?
For the record, I don’t have a problem if the Fed wants to cut rates three times in 2024. The current Fed Funds rate is at the high end of the range it’s been in over the past three decades, so a slow and gradual easing as we eventually make our way back to the Fed’s 2% target inflation rate seems reasonable.
But I also wouldn’t have a problem if the Fed did nothing if some of these economic numbers don’t cool off.
Admittedly, I think the Fed doing nothing in 2024 is a low probability outcome, but one that can’t be dismissed altogether. My current base case expectation is that GDP growth slows as the year progresses and the unemployment rate ticks higher. There’s enough strength in the current economy to suggest that inflation may not be coming down any time soon. Even shorter-term annualized inflation readings show no meaningful progress towards the Fed’s 2% target, especially after this week’s unexpectedly hot reading.
If the Fed follows through on its dual mandate of price stability and maximum employment, there’s no good argument to be made for several rate cuts when core inflation is still running near 4%. The Fed simply has to do what it needs to in order to get inflation under control.
The problem is that the Fed may need to risk a recession in the process. There’s enough current trouble with debt levels, real estate and manufacturing that this may be the outcome regardless of what the Fed does. But Powell may need to eventually choose - inflation or recession. I think he’ll choose inflation. It’s the one thing the Fed has focused on throughout the past couple years and I don’t think there’s reason to believe he’ll change his point of view now.
Conclusion
At the beginning of the year, one of my predictions was that the Fed would cut rates three times in 2024. Not exactly going out on a limb given it’s what Powell himself said he was expecting, but I don’t think we should bet against the Fed at this point. I think that’s still their base case, but I also think they may be getting surprised at how resilient the U.S. economy really is.
At this point, I’d put the chance of zero rate cuts in 2024 at about 5%, maybe 10% if I’m in a bad mood. It’s incredibly unlikely, but it’s not as impossible as most investors think it is.