🔒 Federal Reserve to set market pace more than ever in 2024 – Mark Gilbert

In the complex landscape of global economics, the Federal Reserve’s upcoming decisions loom large, with traders and portfolio managers closely watching for signs of a policy shift. After a series of interest-rate hikes, the market anticipates a swift and substantial easing cycle. Treasuries face an unpredictable journey amid central bank actions, geopolitical uncertainties, and a US presidential election. Meanwhile, the euro zone grapples with a manufacturing recession, and global equities strive to recoup losses. As volatility remains a wildcard, credit markets navigate tightening spreads amidst the delicate balance of improving borrowing conditions and potential policy dilemmas.

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The Fed Will Set the Pace for Markets More Than Ever This Year: Mark Gilbert

By Mark Gilbert and Marcus Ashworth

The surge in consumer prices that drove inflation way past central banker’s targets in recent years triggered a wave of interest-rate hikes. But as policymakers were desperate to rebuild their credibility as overseers of monetary stability, their zeal threatened to savage growth and spark unemployment. The pause in hiking we’ve seen in recent months is now expected to be followed by an easing of policy.

As the charts below argue, what the Federal Reserve does next will be more important than ever in determining how financial markets behave in the new year.

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Don’t Fight the Fed

This truism should become the obligatory screensaver of every trader and portfolio manager. After 11 interest-rate hikes and 525 basis points of tightening, the market senses the tide is turning. Exactly when the US central bank decides to ease is perhaps less important than the speed and scale of the easing cycle — and futures traders are anticipating rapid and deep cuts.

When it comes, the first Fed reduction is likely to be a substantial 50 basis points, and that scale of move could repeat until officials feel monetary policy is no longer restrictive and more in tune with calmer inflation.

The prospective easing cycle is likely to be both quicker and shorter than the last two years of ever-higher borrowing costs. Futures markets badly underestimated the US central bank’s resolve to curb consumer price increases in 2023. Garnering a clearer picture of where official interest rates level out is the big trade for fixed-income markets this year, and will determine the shape of the (currently still inverted) yield curve. In the meantime, most of the world’s central banks are locked in the Fed’s tractor beam — where it leads, others will have to follow.

Treasuries Follow the Path of Most Resistance

Most years, forecasts for where the 10-year Treasury will be by the end of December have typically been over-optimistic — only a 100 basis-point rally in the final two months of last year, taking the yield to 3.9%, saved 2023’s prognosticators from being wildly off-target. 

The current forecast is for the yield to end this year almost unchanged at 3.8% — incredibly, almost exactly where it landed at the finales of both 2023 and 2022. Often, though, it’s the journey rather than the destination that matters. Last year saw a 175 basis-point range; the year before endured a 285 basis-point swing. Fixed-income traders should brace for a bumpy ride as Treasuries get buffeted by central bank mumbling, the forthcoming US presidential election and whatever geopolitics throws up.

Bonds Breach an Important Milestone

After flirting with zero at the start of this decade, government borrowing costs soared last year, with the 10-year average for countries in the Group of Seven breaching 3% for the first time in more than a decade. The 10-year Treasury, the world’s benchmark, peaked at 5% in October, marking a fivefold increase since the beginning of 2021.

A rally in the past two months has driven yields lower. With the exception of Japan, where the central bank dictates levels, markets have moved roughly in lockstep with each other. That looks likely to change this year, with European bonds, including German bunds and UK gilts, set to reflect increasing recession risks while US debt enjoys the soft economic landing the Fed seems to have engineered.

One Aloof Stand Sentinel

The Bank of Japan is alone in persisting with negative official rates — but the clock is ticking. Last month, Governor Kazuo Ueda dismissed hopes for a rise in its minus 0.1% policy rate at the next BOJ meeting on Jan. 23. But it will surely come in the first half. The yen has lost nearly a third of its value against the dollar over the past three years, saddling Japanese industry with soaring import costs. Japan’s government bond market is so ossified it has days when the 10-year benchmark doesn’t trade. Ueda has let bond yields rise gradually, occasionally twitching the reins with unscheduled buybacks, but the 10-year bond is struggling to test the new 1% reference rate.

Japanese inflation has glided down to 3.3% in October after peaking at 4.4%. But the BOJ’s monetary policy isn’t just about banishing deflation — it’s about economic normalization after 15 years in the deep freeze of near-zero rates. Inflation may have been breathed back into the economy, but wider economic freedoms are still desperately needed.

Landing the US (Economic) Plane

“Given how badly the guardians of monetary stability misjudged the post-pandemic environment, we’re skeptical of their ability to concoct a Goldilocks economy,” we wrote this time a year ago. At least with regards to the US economy, the world’s largest, our pessimism seems to have been misplaced.

Bloomberg’s News Trends function, which tallies the occurrences of keywords in articles from more than 1,500 sources, shows how mentions of recession have steadily faded in the past 18 months. With US gross domestic product expanding by 5.2% in the third quarter and consumer price inflation slowing to 3.1% in November, the US central bank seems to have gotten the porridge just right. Let’s hope the chefs aren’t tempted to leave the economy cooking on the gas of high borrowing costs for too long. 

Crashing the  Euro Economy

Manufacturing in the euro zone is in recession — and it’s spreading. Germany’s revered industrial model has been through a systemic shock, with energy costs soaring as access to cheap Russian gas was cut off just as its main export destination of China started struggling. But it’s far from alone, as France is in a severe downturn too, suffering not just from similar issues but also some of its own longer-term malaise. Unlike in the US, the euro-area fiscal stimulus tap has been largely turned off as focus turns to controlling budget deficits.

Growth has turned negative in Germany, along with the Netherlands, but all of the bloc is suffering from recession-like conditions. Following eight years of negative rates, the past 18 months of severe monetary tightening from the European Central Bank is biting hard. Money supply has turned sharply negative, and bank lending is in an extended decline. Expect the ECB to have to cut borrowing costs substantially — once it convinces itself the post-pandemic inflation surge has been beaten.

$111,491,926,101,120

That number — which rounds to a bit more than $111 trillion — is the current global stock market capitalization. A 14% rally last year pared 2022’s 20% decline, which was the worst since 2008’s 47% drop. But the rebound leaves equities still about $10 trillion shy of their November 2021 peak — with China’s 7% decline in 2023 helping to prevent world stocks from regaining their highs.

With US equities setting a blistering pace, a growing number of analysts are predicting further gains for the S&P 500 that will take the index above 5,000 for the first time in the next 12 months. A record high for the aggregate value of the world’s stock markets beckons.

Rumors of the Death of Volatility May Be Greatly Exaggerated

January 2022 saw the all-time high for the S&P 500. As this level gets challenged again, it’s not surprising the VIX volatility measure is at its lowest since late 2019, and within touching distance of the record low of 9.5 seen in September 2017. Equity valuations bumping up against the ceiling tends to result in narrower ranges and thereby declining volatility. But, as early 2020 taught us, when volatility does return it can be with a vengeance, particularly if stocks suffer a downdraft. A break upward to a new range for stocks can also produce a spike.

Being short volatility was a wildly successful trade in 2023, but it’s starting to look like picking up pennies in front of a steamroller. There are several potential catalysts that could upset equities, including an earnings swoon for corporate America, missteps by one or more of the Magnificent Seven or artificial intelligence either proving to be a false dawn or inspiring a regulatory crackdown. Stay nimble.

Credit Where It’s Due 

The yield premium companies have to pay compared with government debt has been declining in recent months. US corporate bonds are performing best, driven by ongoing fiscal stimulus programs, such as the Inflation Reduction Act. But the effect is also noticeable in euro-area credit — even as the bloc teeters on recession.

US credit spreads ended the year on their lows, with euro-area equivalents the lowest since April. The risk is that if financial borrowing conditions continue to rapidly improve, central banks will be less confident about easing policy. This poses a dilemma for corporate debt — swift rate cuts will only come if growth noticeably weakens, but recession is usually kryptonite for all but the safest of credits. S&P Global Ratings expects further deterioration this year, with nearly 40% of lower-grade firms at risk of downgrades. Consumer-facing and real estate sectors are the most vulnerable. Corporate spreads can’t have it both ways — and a lot of optimism is already priced in.

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