The peculiar market divide on the rate outlook

The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy

Something peculiar is unfolding once again in the relationship between financial markets and the US Federal Reserve.

A disagreement has emerged over the interest rates that the Fed will set in 2024. The more investors disregard the signals emitted by the world’s most influential central bank, the more likely they will find themselves on the losing side of this debate. And the longer this phenomenon persists, the more intriguing the related complexities.

This situation became vividly evident in the lead-up to the current “quiet period” for officials on public comments slated to end on December 13 with the conclusion of the Fed’s policy meeting. In this period marked by dovish interpretations — or selective hearing — by markets of several Federal Reserve speeches, all attention was focused on whether chair Jay Powell’s remarks at the end of that week would push back against the market consensus predicting rate cuts starting in early 2024.

Powell attempted to do so in two lines of argument. First, he emphasised that “it was premature to conclude with any confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease”. Second, he reminded markets that he and his colleagues on the Fed’s policy-setting committee “are prepared to tighten policy further if it becomes appropriate to do so”. However, these attempts proved unsuccessful, judging by the market reactions.

One would expect these signals to partially reverse the eye-catching movement in yields observed in November — a fall of more than 0.60 percentage points for the 10-year Treasury bond and more than 0.40 points lower for the rate-sensitive two-year note. Instead, yields fell by another 10 basis points on the day of Powell’s remarks, leading to markets pricing in by the end of that week a total of five cuts in 2024, with a notable probability of the first one coming as early as March.

What adds to the peculiarity is that this is not the first time markets have challenged the Powell-led Fed view on the monetary policy outlook. Just a year ago, a similar scenario unfolded, with markets pricing in cuts for 2023 that never materialised. Consequently, government bonds had a bumpy year and, until November’s robust rally in yields, faced the prospect of a third consecutive year of negative returns.

There is a third peculiarity: the more markets diverge from the Fed’s signals, the more likely they are to push the central bank to adopt the path that is detrimental to them. This is because markets’ affinity for rate cuts loosens financial conditions and heightens the Fed’s concerns about inflationary pressures, thereby delaying the rate cuts that the markets are betting on. Indeed, according to a Goldman Sachs index, November was among the largest monthly loosenings in financial conditions on record.

As to the why, markets may be willing to risk another beating from the Fed because they are more concerned about a possible recession in 2024. This would align with developments in gold and oil prices but appears inconsistent with a surge in stock prices.

Alternatively, the markets might believe that while the Fed officially targets a 2 per cent inflation rate, it might understandably tolerate a slightly higher figure (3 per cent). This aligns with the notion that, having grappled with insufficient aggregate demand in the previous decade, the global economy has entered a multiyear period of less flexible aggregate supply.

Factors such as the energy transition, fragmented globalisation, corporate emphasis on resilient supply chains, and less adaptable labour markets contribute to such a shift. Pursuing too low an inflation target in this environment would result in unnecessary sacrifices in growth and livelihoods, as well as a worsening of inequality.

The third explanation centres on the Fed’s loss of credibility. This is due to its mischaracterisation of inflation, delayed policy measures, supervisory lapses, poor communication, repeated forecasting errors, questions over the trading of some officials, and weak accountability.

Based on the market’s own consensus forecast of the economy and the levels of equity valuations, interest rates could well remain unchanged for longer than what the futures market currently implies. To avoid another potential setback, investors should either prepare for the possibility of higher yields in 2024 or adjust stock valuations accordingly.