The Fed switches to loosening bias as Powell plays Santa Clause

The bulls in financial markets received an early Christmas present from the Federal Reserve on Wednesday, when the Fed signalled that they are seriously considering when to cut rates and that keeping rates at the current high level could damage the economy. There had been much speculation in recent weeks about when the Fed would confirm that they are shifting from a tightening bias to a loosening bias, and today that shift happened. The Fed is wary not only about inflation, but also about the impact of high interest rates on growth, and this has set markets on fire. The S&P 500 reacted with a broad-based rally, in particular for the real estate sector, which rose 3.58% on Wednesday, there were also gains for consumer discretionary, up 1.35% and financials, up 1.6%. Even the embattled oil price spiked on the back of this Fed meeting, and the Brent crude spot price was up more than 1.73%.

There were three aspects of the last Fed meeting of the year that should stand out for traders and investors:

1, Changes to the Dot Plot.

Fed officials now expect 3 interest rate cuts in 2024, up from 2 in the September projections. The mid-point in the range of expectations for interest rates next year is now 4.63-4.87%, and for 2025 the Fed is expecting a further 4 interest rate cuts, which leaves the mid-point for interest rate expectations for 2025 at 3.38-3.62%. This is a large shift, back in September the mid-point for interest rate expectations was 5.1% for next year, thus the Fed has made quite the pivot at this meeting.

2, Where has the caution about inflation gone?

Ahead of this meeting, some analysts expected a cautious Fed who would push back on expectations for interest rate cuts next year. There was a concern that the Fed chair would not want to declare victory over inflation too early and make a mistake like Arthur Burns in the 1970s. There was a fear that the Fed could unleash even more market loosening that would make inflation worse down the line. However, while the Fed did not go as far as to declare that the fight against inflation was over, for the first time in this monetary policy cycle the Fed’s statement sounded more concerned about growth than inflation worries. The Fed is also expecting to cut rates for all of the right reasons. The central tendency in the Fed’s GDP projections is not looking for a recession in the next 3 + years, although growth is expected to slow considerably from the Q3 rate. GDP is expected to be between 1.2-1.7% next year, and 1.5% - 2% next year. At the same time core PCE inflation, the Fed’s preferred inflation measure, is expected to decline to 2.4-2.7% next year and 2-2.2% in 2025. The September projections had been for core PCE to fall between 2.5-2.8%, and for the 2025 rate to be between 2-2.4%. These declines are slim margins, but the fight to bring inflation back towards the Fed’s 2% goal looks like it will continue, and the trend for lower inflation is maintained, according to Fed officials. Thus, the Fed rate cuts that are expected in the coming years are for all the right reasons – because inflation is falling – rather than because growth is falling off a cliff.

3, The US yield curve

After the Federal Reserve rate decision, the US 2-year Treasury yield fell by a staggering 30 basis points to 4.25%, the lowest level since June. At the same time, the 10-year US Treasury yield fell by 17 basis points, and is currently yielding 4.025%, the lowest level since August. The 10-year yield is below the 2-year yield, which means that the US yield curve has fallen further into inversion territory, which is traditionally a signal that a recession is imminent. How can this be, when above we have said that the Fed is cutting interest rates for all of the right reasons and that a recession is not on the cards? There is a good argument that the yield curve is not the recession forecaster it once was because of distortions to the US economy caused by the pandemic. However, it highlights a problem that the Fed faces now that long term rates are below short-term rates. If there is not going to be a recession, then the Fed will not want longer term interest rates to fall too far in case that spurs inflation down the line and also triggers too much loosening in financial conditions. Thus, the Fed is facing the dilemma where rates are too high (short end) and too low (long end) simultaneously. Going forward, the Fed may try to engineer the market response to its commentary by trying to lower short term yields and raise longer term yields, in an attempt to steepen the yield curve. One way to do this is to lift the longer run expectations for interest rates. The Fed projects that this will be between 2.38- 2.62%. The next set of Fed projections will be released in March, if the US economy keeps ticking along until then, there is a chance that we will see the longer run interest rate expectations increase. At that point, we will need to see if the market rally can be sustained even if long term yields start to rise.

Overall, the everything rally that started in November was given a new lease of life on Wednesday, and we expect the market euphoria to last into Thursday. This Fed decision has touched all major asset classes, bonds are higher (yields lower), and the dollar is weaker across the board. USD/JPY is down 1% in the last 5 days at 142.60, while GBP/USD is marching higher again, and could attempt to break through key short-term resistance at $1.27. Gold is up by more than $2 on Wednesday, this may seem strange since the yellow metal is a traditional inflation hedge, but maybe traders are trying to hedge their bets in case inflation flares up down the line? Bitcoin fell on the back of the Fed meeting and is down more than 2% so far this week. Some may argue that there is only so far bitcoin can rally, and when the market is rallying for a fundamental reason – such as a major shift in Fed policy – then it’s fair game that bitcoin does not join in the party.

Overall, as we leave Wednesday’s excitement behind, all eyes will be on the ECB and BOE meetings on Thursday to see if they follow the Fed and shift to a dovish narrative. If they do, then it could stir up more bullish sentiment in financial markets.