Powell delivers early fireworks to markets

The Fed buys into market narrative

Last night the FOMC bought into the recent market narrative pricing in rate cuts next year as inflation continues to cool, although in the short term US core services inflation remains high, forecasting three rate cuts next year compared to five cuts priced by the market (see price chart of SOFR Dec 2024 below). The message extended the rally in equities pushing Nasdaq 100 futures to a new all-time high on the close and the move has extended today with the index futures trading around the 16,850 level. It is not unrealistic to think that the S&P 500 could hit 5,000 in a complete melt-up scenario by yearend.

From a strategic perspective the Fed is happy with its policy forecast spread to market pricing on rate cuts as any error will force the market to correct first creating a buffer for policymakers. As such the Fed will likely continue to update its forecasts for rate cuts in tandem with market pricing keeping a certain spread in place with two rate cuts being the current spread. Some say that the market is getting too aggressive in its pricing but history is on the side of markets because when a rate cycle begins the policy rate trajectory often accelerates faster than most anticipate. This could easily happen again.

The logical narrative in the market is that the policy rate repricing drives the market through valuation expansion, but as our chart below shows there has been little logical connection between the market’s pricing of Fed policy rate Dec 2024 and the forward equity valuation of the S&P 500. In other words, if the repricing matters for equities is a local phenomenon and not a generalized dynamic. As we have been writing for quite some time, the market’s logic is this. As long as the policy rate is only projected to fall less than 200 bps then the interpretation is a soft landing meaning lowering discount rate on cash flow with stable nominal growth of 4-6%. This will support the positive momentum in equities, but if the policy rate pricing exceed the 200 bps then the equity market will begin realising that policy rate cuts are suddenly an expression of an incoming recession and then the market dynamic will flip upside down.