Stocks continued to drift higher last week. Friday’s employment report matched expectations and supported the conclusion that a soft landing was the most likely economic outcome for 2024. Almost all the gain in jobs last month came from the health care and government sectors. In the private sector, we fear layoffs. In the government world, they lay on.
This week’s focus will be on Wednesday’s FOMC meeting conclusion. Most specifically, analysts, investors, and economists will be watching the dot plots of expectations laid out by meeting participants. According to polls and futures markets, the public today believes there will be as many as seven cuts in the Federal Funds rate in 2024 beginning in March. According to the most recent dot plots issued in September, Fed officials believe there will be two beginning in the fall. The private sector forecasts are real time; the Fed’s are three months old. That is why bringing the Fed’s forecast up to date is so important. Rarely are the Fed and non-government forecasters so dispersed in their judgment. One would expect the Fed to move in the direction of the private sector’s outlook. But how far? That’s the big question.
Almost everyone outside the Fed thinks it is done raising interest rates, at least for this economic cycle. That includes those believing in a soft landing and those who believe in recession. But can the Fed make an absolute statement without boxing itself into a corner from which it can’t escape? The answer is yes. There is always a black swan risk that some event will force it to switch course and raise rates again. For instance, in late 2019, no one saw a pandemic that would shut the world down three months later. But if the Fed wants to keep the door open to future rate increases, it needs to justify doing so. Does anyone see an environment whereby inflation returns to a high single digit pace in the near-term? That could happen in the future if the Fed returns short-term rates to zero while fiscal deficits skyrocket further. But those are both big ifs, not expected realities. Thus, if the Fed can’t make a logical case for interest rate increases over the next several months, it would be best served to say so.
Saying rate increases are off the table doesn’t require stating when the first rate cut might occur. That’s where the dot plots come into play. These represent the personal outlooks of meeting attendants. As I often note, the accuracy of dot plot predictions is notoriously bad. One shouldn’t take them at face value. But what they do show is what is in the collective heads of meeting participants today. What we are likely to see Wednesday is the following. First, an increased confidence that inflation is moving in the right direction. Second, an understanding that tight monetary policy is working, that the economy is slowing down. Third, parts of the economy are still running a bit hotter than the Fed wants to see. Job creation should be closer to 100,000 per month rather than 150,000-200,000. Wage growth is still around 4%, tolerable but a bit higher than hoped for. Service inflation is still a bit hotter than preferred, but all are moving in the right direction. Those within the Committee who worry the most may still want to delay the first rate cut beyond spring when markets predict it will happen. But just as Fed officials are bad prognosticators, so are private sector forecasts. March might prove to be too early for the first cut. The fall seems a bit late. Hopefully, the range of expectations will tighten after Wednesday’s meeting.
This all plays out in the bond market. Currently Fed Funds rates are within a 5.25-5.50% range. Treasuries maturing within 6 months are within that same range. Even yields on 1-year Treasuries are close, currently just under 5.2%. But from there it starts to fall off. 2-year yields are now about 4.75%. Not long ago, they were near 5.4%. 3-year yields are down near 4.5%. For 5 to 10-year maturities, the yields are in the 4.25-4.30 range. Very flat. The way the yield curve is likely to uninvert is for short-term rates to come down reasonable quickly as the Fed starts to move from a tight to a neutral monetary policy while yields at the long end of the curve stay about where they are.
In some interest rate cycles, as interest rates and inflation peak, it pays to lengthen maturities to lock in high yields. That was most applicable in the early 1980s when both long and short-term interest rates were 15% or higher. Once Paul Volcker made it clear that he was going to crush inflation, locking in double digit rates for a decade or longer made much more sense over almost any time horizon than sticking to money market funds, where rates would come crashing down in a pending recession.
But this time is different. Long-term rates, now near 4.25%, are not likely to deviate a whole lot over the next several years. It is unlikely inflation will morph into deflation. It is also unlikely that the Fed will repeat some of the easy money mistakes of the past two decades, bringing the Fed Funds rate to near zero and sparking a surge in stupid investments. Look at all the circa-2021 SPACs now selling for less than $1 per share. Thus, there is little urgency to lock in a 4.25% rate. Those rates could actually go higher if the U.S. government doesn’t get some control over the size of future deficits or if the Fed decides to cut rates too rapidly.
As for short-term rates, they will come down as the Fed eases. Thus, sticking totally with money market funds makes little sense. Rather a ladder of 2–5-year maturities is worthy of consideration. Such a ladder gives up a bit of income short-term. But if the Fed is going to cut the Fed Funds rate back toward 3% over the next two years, one will come out better using a bond ladder than sticking with securities maturing within 90 days. Right now, there isn’t an urgency to move today unless one expects the Fed to pinpoint when the first rate cut might occur. As noted earlier in this Comment, the Fed could, and logically should, take any further rate increases off the table. But there is little to be gained tying itself down as to when rate cuts might begin.
How does this affect equities? They key off of long-term rates. Nothing I said this morning nor recent economic data suggests a monumental move in either direction. Should a soft landing happen without inflation, one could argue that earnings over the next twelve months could be a bit better than current expectations. Conversely, even a mild recession could cause earnings to miss on the downside. The Fed’s actions and comments Wednesday shouldn’t move the needle much, if at all. The biggest problem facing equity investors today is valuation. Stocks are cheaper than they were at the end of 2021 but more expensive than they have been on average over the last several decades.
Today, John Kerry turns 80.
James M. Meyer, CFA 610-260-2220