The Market Might Be Setting Up For A 20% Correction & It Wouldn’t Be The Fed’s Fault

Investors' belief that a massive central bank rate cutting cycle is coming in 2024 will likely cost them dearly.

Of all the economic and financial market numbers that are making the rounds right now, the one that gets me the most is 6.

That’s the number of rate cuts that are getting priced in for 2024, according to the Fed Funds futures market. If you want to get more specific, investors are saying there’s an 80%+ chance that there will be six or more rate cuts this year. Investors aren’t expecting just a new rate cutting cycle by the Fed. They’re expecting an aggressive. In my opinion, a much too aggressive one.

Contrast that with the December dot plot report from the Fed, which indicated a median expectation for three rate cuts in 2024. When there’s that large of a disconnect between what the Fed expects will happen and what the market expects will happen, that creates a problem for both stocks & bonds and it’s one that’s likely to get rectified one way or another this year.

The big question, of course, is which one of them will prove to be right (yes, I suppose neither of them could be right, which would be very on-brand with what’s happened lately, but let’s assume for the time being that it’s just a choice between A and B).

It’s this dovish pivot by investors that fueled the big rally we saw in the 4th quarter of last year. Powell made the indication that monetary conditions were sufficiently restrictive and that’s all it took. Inflation expectations came down, therefore interest rates came down, therefore stocks and bonds rallied.

“The Fed Funds rate should be up here!”

Now that stock and bond prices have leveled off, yet the Fed Funds futures market is still expecting 6-7 rate cuts, it feels safe to say that these rate cut expectations are fully priced in. Unless something major occurs, there’s little reason to believe, in my opinion, that there’s further upside for risk asset prices based solely on monetary policy expectations. After all, how bullish can one really get on the prospect of further rate cuts? I mean, there’s a reason why central banks need to cut rates quickly and it’s usually not a good one.

There is plenty of downside though. In 2022, the markets kept trying to talk themselves into the idea that the Fed was ready to pivot even though Powell was consistent in his message that policy rates were going to be getting more restrictive in order to tame inflation. He never wavered and stocks eventually cracked each time their optimism balloon was popped.

Take a look at this S&P 500 chart from 2022 and see if you can figure out where investors expected a pivot and where Powell essentially told them no.

Here’s my prediction for 2024: Powell’s going to stick to his guns again. Sure, we’ll probably get a few rate cuts this year since inflation is back within the realm of normal. With core inflation still running at a 4% annualized rate and showing no signs of a sustainable trend towards 2%, the Fed very likely isn’t in any particular hurry to make a significant change to interest rates and they have a strong case for not so doing so.

If the Fed uses elevated inflation as its reasoning for going easy on rate cuts, the market needs to reprice their expectations for policy easing. That means higher for longer, which means bond prices fall as rates adjust higher and that spills over into lower stock prices.

If the market goes from pricing in seven rate cuts instead of three and long-term rates rise by 100 basis points, that equates to roughly a 17% loss for the iShares 20+ Year Bond ETF (TLT) based on its current portfolio duration. The downside for equities is less clear, but they dropped more than 20% at one point in 2022 when expectations for Fed dovishness got shut down. It could very well happen again.

For as much as we like to blame the Fed for their mistimed policy decisions, this time the fault wouldn’t be theirs. It would be the fault of investors!

They’ve gotten way ahead of themselves because a massive rate cutting cycle is what they want, not what makes sense. Powell has repeatedly said that inflation control is his #1 priority. With core inflation at 4% still, he has every justification to keep interest rates elevated to make sure the job gets done.

Look at it this way. Stripping away what we know about the environment today and all of the current context, what would your reaction be if I told you that the Fed was considering cutting the Fed Funds rate by 175 basis points while the core inflation rate is 4%? You’d say that Powell is nuts. And you’d be right. That is nuts. But it’s what the market seems to think he’s going to do. Powell is saying he’s not, but investors just aren’t listening.

In summary, use this to your advantage instead of following the crowd here. The Fed has said that it’s expecting three rate cuts this year. You’d be wise to take them at their word until we have reason to believe otherwise. Powell stuck to his plan in 2022 and he probably will again in 2024. That means the market is going to reprice in higher rates at some point this year, which will almost certainly lead to a correction in stocks & bonds.

Stay prepared. It’s likely heading our way.