Head of Saxo Strats
Summary: The market is increasing its confidence that the Fed will cut its policy rate at the March meeting starting a rate cut cycle. We take a look at previous initial rate cut cycles and how the US equity market responded to in the first 90 trading days to such a rate cut. We discuss the conflicting signals in the economy between financial conditions that have eased substantially against the easing inflation setting up a difficult decision for the Fed because which factor should they emphasize in the short run.
Since 19 October the market has drastically altered its view on inflation and more importantly policy rates set by the Fed and ECB. As the US SOFR (Secured Overnight Financing Rate) Dec 2024 contract is showing the market has moved the 2024 terminal Fed Funds rate lower by almost 100 bps. This repricing has fuelled sentiment in equities delivering one of the strongest months in 20 years in equities. The SOFR futures forward curve is now pricing in 5 rate cuts by December 2024 with the Fed rate cut coming at the Fed meeting on 20 March.
There have been 9 initial Fed rate cuts starting a rate cut cycle (shorter or longer) since 1 January 1985 and if we look at the S&P 500 performance during these periods then the US equity market tends to rise in the subsequent 3 months after a rate cut cycle has begun. Remember that with only 9 rate cut cycles the statistics here come with small confidence and investors should take note of the current situation instead of blindly trust history. The average S&P 500 gain during the 90 trading days after an initial Fed rate cut is 5.1% which is significantly above the normal 3-month S&P 500 return which is in the 2-2.5% range.
History gives us the clue that an initial rate cut by the Fed is often interpreted by the market as a natural initial adjustment of policy rates to changing circumstances. But the market is rarely coupling the initial rate hike with an incoming recession. If that was the case history would a more clear downward direction in equities post an initial rate hike. This is also likely the reason why equities have rallied since mid-October. The equity market sees the current priced in rate cuts as a natural adjustment to lower inflation and not a sign of a recession. Should SOFR futures suddenly rally a lot higher from here then it would be a sign that rates traders are seeing a recession coming and then the interpretation by equities will flip on dime.
Another striking difference in the market is the median recession probability by economists tracking the US economy. The probability is at 50% which is a huge divergence from equity markets which are closer to all-time highs and thus signalling less than a 10% probability of a recession.
The prevailing narrative driving the repricing in policy rates is that central banks won over inflation. Although premature and we have little data to base our understanding of the new structural inflation level in the economy, that is nevertheless what the market is running with. Now, one thing is inflation coming down, another is financial conditions which the Fed is also paying close attention to. If look at the Fed’s own adjusted financial conditions index then it now the loosest since the rate hike cycle began back in early 2022 and financial conditions have ease substantially in the past two months.
Looser financial conditions will help underpin financial markets and more importantly the economy. There are no signs that financial conditions are getting too tight and thus if the Fed followed their own methodology they would sit tight for longer avoiding a repeat of the 1970s where they cut the interest rate too quickly.
There is final unknown in all of this and that is China. The false starts in 2023 and the widening cracks in the economy is forcing the Chinese leadership to act in their own self-interest. The CCP’s Politburo is about to set the date for the third plenum which will gather extra attention this time around because China’s economy is seen as weakening. If China goes bold regardless of the obvious weakened fiscal transmission due to the old economic model is currently broken (real estate and infrastructure spending) then that could be a surprise factor for the global economy and inflation. The Fed and ECB are well aware of this. So 2024 will start with a high stake poker game in world of policy rates.
2024: The wasted year
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
