Key takeaways:
- The Fed left rates unchanged at its December meeting after one of the most aggressive interest rate cycles in modern history.
- Bond and equity markets rallied in Q4 on hopes that the Fed is ready to pivot to lower rates sooner than later.
- Despite the market’s optimistic take, the Fed maintained a hawkish bias, signaling it may have more work to do taming inflation and cooling economic growth.
- Rain portfolios are well prepared to weather economic deceleration this year with an emphasis on the income and safety of bonds and Low Correlation Growth strategies to buffer equity volatility. This caps an especially volatile three-year period during which Rain portfolios demonstrated very strong relative performance to benchmarks.
Market Update:
The US economy held up better than expected in 2023 despite aggressive interest rate hikes, turmoil in the banking sector and geopolitical stress. Several factors contributed to this resilience. Restrictive monetary policy raised borrowing costs without triggering severe tightening in broader financial conditions, corporate profit margins remained healthy, consumer spending held up well, easing supply chain bottlenecks contributed to declining inflation, and the labor market continued its post pandemic recovery. However, a number of factors will weigh on the US economy that will likely lead to slower economic growth, a process that is already underway in most of the rest of the developed world.
Meanwhile, with inflation easing and unemployment rates beginning to trend higher, the Fed voted to leave interest rates unchanged at its December meeting. After hiking rates a cumulative 5.25 points since March 2022, the Fed’s “pause” gave markets the impression that the central bank is ready to pivot to easier monetary policy in 2024. This expectation sent markets significantly higher in Q4. The Fed, however, maintained a hawkish bias in its forward guidance, likely to temper market expectations and out of fear of repeating the mistake of the 1970s when then-Fed Chair Arthur Burns declared victory over inflation too early and with disastrous consequences.
When considering how soon and by how much the Fed might cut rates, it is important to note that historically, central banks have not preemptively cut rates ahead of recessions. Rather, interest rate cuts have tended to coincide with rising unemployment and a falling output gap (the difference between real GDP and potential GDP). Even in the few instances when a central bank has cut rates in the absence of a recession, inflation had definitively peaked while the unemployment rate had risen toward its longer-term average.
We’re not there yet. At the moment, while readings of headline and core inflation have clearly peaked and the unemployment rate has started to edge higher, there are plenty of mixed signals under the surface of these measures. While the unemployment rate has begun to edge higher, labor markets remain historically tight, and less progress has been made reducing inflation in wage-sensitive core services outside of housing. (The Fed has zeroed in on this when referencing persistent inflation pressures). When unpacking price pressures in core services, the bulk comes from transportation services, which includes items like automotive insurance and auto repair costs. The expectation is that as auto parts inventories are replaced, prices should feed through this category and, together with easing wage pressures and cooling consumer demand, reduce price pressures in this area in the coming year. Finally, even given the progress on inflation and unemployment, the Fed still must be mindful of the fact that the output gap, rather than falling, has been steadily increasing since Q2 of 2022, a feature that will further complicate the Fed’s decision making.
Just as the Fed was late to rate hikes in the face of surging prices, we would expect the Fed’s tendency to ease interest rate policy in the face of decelerating growth and prices to lag as well. This is based both on the unspoken preference of the Fed to avoid a repeat of the inflation nightmare of the 1970s as well as the unique difficulty of forecasting in a post-pandemic economy that has been hit with numerous supply shocks. It also reflects the reality that central banks tend not to cut until they are fairly confident that the economy has entered a recession with unemployment rising. The safer path when cutting in the aftermath of an inflationary spike – and the one that ensures central bank credibility – is to wait and see. Waiting buys flexibility should the economy continue to prove more resilient than expected.
The implication of lagged interest rate policy is that once the Fed does begin cutting, those cuts are likely to be more aggressive than markets may expect. Right now, there is a large mismatch between market expectations and the Fed’s estimates of interest rate policy, with the market anticipating significantly larger and earlier cuts than what the Fed is signaling. The market is either not buying the Fed’s higher-for-longer message or doesn’t believe the soft-landing story. Either way, this discord will likely create volatility in markets as time and data enforce some agreement between the two.