The expected end of the Federal Reserve's post-pandemic rate hike cycle triggered a rally in stocks and bonds, but investors risk timing the shift in monetary policy wrong.
For the fourth time in five meetings, the Fed on Dec. 13 decided to hold rates at current levels, killing the chance of one last rate hike before the end of 2023. Meanwhile, the majority of Fed officials also expect 75 basis points worth of rate cuts in 2024 and 100 bps worth of additional cuts in 2025, according to the latest economic projections released at the conclusion of the meeting.
This, combined with a perceived dovish tone from Fed Chairman Jerome Powell in his press conference, pushed the S&P 500 to its highest level since early 2022 and caused bond yields to tumble at a pace last seen during the banking turmoil in March. Yet the market may be overlooking the danger that a shift from rate hikes to rate cuts may not be imminent, and further policy tightening remains a possibility if wage growth remains hot and inflation fails to slow meaningfully.
"I'm worried about the exuberance because the market is going too far too quickly," said Tim Horan, chief investment officer for fixed income at Chilton Trust. "Powell was very clear that rate hikes are not off the table."
Timing rate cuts
Throughout his Dec. 13 press conference, Powell said the central bank remains committed to getting inflation growth back to 2%, but he said, for the first time, that it would be a mistake to wait until it returns all the way to 2% before loosening policy. The majority of Fed officials do not see the core personal consumption expenditures index, which strips out volatile energy and food prices, falling to 2% until 2026, according to the Fed's latest projections.
Shortly after Powell's press conference, the majority of the futures market was betting that the first rate hike would take place at the Fed's March meeting, according to the CME FedWatch Tool, which measures investor sentiment in the Fed funds futures market.
"The timing is still very uncertain," said James Camp, managing director of fixed income and strategic income at Eagle Asset Management.
Camp does not see the Fed cutting rates during the first quarter of 2024 as many of the effects of its 525 basis points' worth of rate hikes since March 2022 fully take root. Consumer spending is likely to slow, credit conditions will tighten further and lending will slow. But if the labor market remains tight and wage growth remains elevated, a lack of movement in inflation could prevent cuts.
The market is likely pricing in cuts earlier than the Fed will likely act, said Sue Hill, senior portfolio manager at Federated Hermes.
"We don't think that the Fed sees the case for easing that soon based on recent economic data, and it seems likely that they would lean more toward keeping policy restrictive for longer than needed rather than easing prematurely and putting its progress on inflation at risk," Hill said.
Consumer health
Much of the outlook for the economy and monetary policy depends on consumers, James Knightley, chief international economist with ING, wrote in a Dec. 13 note.
As real household disposable incomes flatten, credit demand falls and savings built up during the pandemic disappear, a "marked slowdown" is likely through 2024, Knightley wrote.
Knightley expects that this will compel the Fed to begin cutting rates in May, with 150 basis points of cuts in 2024 and another 100 bps in early 2025.
"We think the Federal Reserve will end up being more aggressive on rate cuts than both they and the market are currently expecting," Knightley wrote.