The stock markets are ahead of the Fed

It’s too early to start celebrating. That’s the Federal Reserve’s down-to-earth message – even if the markets don’t heed it even if they get the slightest chance.

At a news conference on Wednesday and in written statements after the latest policy meeting, the Fed did what it could to curb Wall Street’s enthusiasm.

“It’s far too early to declare victory and there are certainly risks” still facing the economy, said Federal Reserve Chairman Jerome H. Powell. But stocks shot higher anyway, with the S&P 500 on the brink of a new all-time high.

The Fed indicated that it was too early to count on a “soft landing” for the economy – a reduction in inflation without a recession – although that is increasingly the Wall Street consensus. An early decline in the federal funds rate, the short-term rate that the Fed directly controls, is also no certainty, although Mr. Powell said the Fed has begun discussing rate cuts and markets are increasingly counting on them.

Markets have been rising since July – and positive since late October – on the assumption that really good times lie ahead. That could prove to be a correct assumption — one that could prove useful to President Biden and the rest of the Democratic Party in the 2024 elections.

But if you were looking for assurance about a joyful 2024, the Fed didn’t provide it at this week’s meeting. Instead, it went out of its way to say that it is positioning itself for maximum flexibility. Prudent investors may want to do the same.

Reasons for optimism

On Wednesday, the Fed said it would leave the federal funds rate as it stands now, at about 5.3 percent. That is about 5 percentage points higher than at the beginning of 2022.

Inflation, the glaring economic problem at the start of the year, has fallen sharply, partly thanks to sharp interest rate increases. The consumer price index rose by 3.1 percent over the year to November. That was still significantly above the Fed’s target of 2 percent, but well below inflation peak of 9.1 percent in June 2022. And because inflation has fallen, a virtuous cycle has developed from the Fed’s perspective. Now that the federal funds rate is substantially above inflation, the real interest rate is at that level rising since July, without the Fed having to take direct action.

But Mr Powell says interest rates must be “sufficiently restrictive” to ensure inflation does not rise again. And he warned: “We will need further evidence to be confident that inflation is moving towards our target.”

The good thing about the Fed’s rate tightening so far is that it has not caused a sharp rise in unemployment. The latest figures show that the unemployment rate in November was only 3.7 percent. On a historical basisThat’s an extraordinarily low rate, associated with a robust economy, not a weak one. Economic growth accelerated in the three months to September (the third quarter), with gross domestic product rising 4.9 percent year-on-year. That looks nothing like the recession that was widely expected a year ago.

On the contrary, with indicators of robust economic growth like these, it’s no wonder that longer-term bond market yields have fallen in anticipation of Fed rate cuts. The federal funds futures market on Wednesday predicted cuts to federal funds starting in March. By the end of 2024, the futures market expected the federal funds rate to fall below 4 percent.

But on Wednesday, the Fed forecast a slower and more modest decline, putting interest rates at about 4.6 percent.

Too early to relax

Several other indicators are less positive than the markets. The pattern of government bond yields, known as the yield curve, has been predicting a recession since November 8, 2022. Short-term interest rates – especially for government bonds with a term of three months – are higher than those with a longer term – especially for government bonds with a term of ten years. . In financial jargon, this is an ‘inverted yield curve’, which often predicts a recession.

Another well-tested economic indicator is recession warnings. The leading economic indicatorsan index formulated by the Conference Board, an independent business think tank, “signals a near-term recession,” Justyna Zabinska-La Monica, a senior manager at the Conference Board, said in a statement.

The consensus of economists, measured in independent surveys from Bloomberg and Blue Chip Economic Indicators, no longer predicts a recession in the next 12 months – a reversal of the view held earlier this year. But more than 30 percent of economists in the Bloomberg survey and more than 47 percent of those in the Blue Chip Economic Indicators disagree, believing that a recession will indeed happen in the coming year.

While economic growth, as measured by gross domestic product, has soared, early figures show show that interest rates are slowing significantly as the steep interest rate gradually damages consumers, small businesses, the housing market and more. Over the past two years, fiscal stimulus from remaining pandemic aid and budget deficits has countered restrictive efforts. of monetary policy. Consumers decisively spent money in stores and restaurants, preventing an economic slowdown.

Yet a parallel measure of economic growth – gross domestic income – has been much lower than GDP over the past year. Gross domestic income has sometimes proven more reliable in measuring growth slowdowns in the short term. Ultimately, the two measures will be reconciled, but which direction will take months to come.

The markets

The stock and bond markets are keen to put an end to monetary belt tightening.

The US stock market has already fought its way up this year and is almost back to its January 2022 high. And after the worst year in modern times for bonds in 2022, market returns for the year are now positive for investment bonds. bond funds – which track the benchmark Bloomberg US Aggregate Bond Index – that form part of the core investment portfolios.

But based on corporate profits and revenues, US stock prices have been depressed, and bond market yields reflect the consensus view that a soft landing for the economy is all but certain.

These market movements may be completely justified. But they imply near-perfect Goldilocks economics: Inflation will continue to fall, allowing the Fed to cut rates early enough to avert economic disaster.

But the excessive market exuberance itself could distort this outcome. Mr. Powell has spoken extensively about the tightening and easing of financial conditions in the economy, which are determined in part by the level and direction of the stock and bond markets. Too big a rally that happens too early could prompt the Fed to delay rate cuts.

All of this will influence the 2024 elections. Prosperity tends to favor incumbents. Recessions generally favor challengers. It’s still too early to make a sure bet.

Without certain knowledge, most investors are best prepared for all eventualities. This means that we must remain diversified, with a broad portfolio of shares and bonds. Hang in there, and hope for the best.

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