The view from a peak in rates may still be cloudy


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Moments of clear agreement in markets are rare and typically fleeting. This week saw one, however, when soft US inflation data convinced investors that the Federal Reserve will not raise interest rates in December.

Any consensus in the outlook for the past weeks of a rollercoaster year is a real relief. Investors can enjoy it — while it lasts. Tuesday’s inflation numbers painted a better than expected picture with the core rate falling to a two-year low of 4 per cent in October.

Analysts joked they could now plan holiday parties for the week of the Fed’s mid-December meeting. Markets made merry right away, with the S&P 500 enjoying its best day in more than six months while two-year Treasury yields tumbled almost 0.25 percentage points.

Futures markets just two weeks ago had reflected expectations of a one-third chance of a higher rate by year-end. Now the market is pricing in a 100 per cent probability that benchmark rates will be kept on hold at the Fed’s policy meeting next month at the current target range of between 5.25 per cent and 5.5 per cent, according to the CME’s FedWatch tool.

Why so certain when we’ve been here before? In this rate cycle alone, this is the seventh time that investors have anticipated the Fed turning dovish, according to Deutsche Bank’s analysts.

The most recent occasion, in March, was related to fears that US banking turmoil would spread and before that, in September last year, to worries that trouble in the UK gilt market would have wider ramifications.

Three earlier episodes in 2022, as rate rises got under way, were the result of concerns the US economy was not strong enough to handle tighter monetary conditions, especially with the start of war in Ukraine.

During most of the occasions when investors bet that rates had peaked, stocks rallied strongly on hopes that easier conditions would boost growth. On this occasion, several softer pieces of data have helped support the belief that this time is really the turning point.

US unemployment has crept up to 3.9 per cent, retail sales growth has slowed and manufacturing surveys are weakening. All of those should help convince the Fed the economy is coming off the boil. Just over two weeks ago, Fed chair Jay Powell himself described the central bank’s stance as “proceeding carefully” “in light of the uncertainties and risks, and how far we have come”.

The danger for investors though comes as markets move past any pause to expecting rapid rate cuts. The CME’s FedWatch tool suggests a two-thirds chance that rates will be a full percentage point lower by the end of next year, with the first cut coming as soon as June.

It could well be that futures markets in fact reflect very divided views — with some investors thinking the fight against inflation will require the Fed to hold rates higher for longer while others bet that the full impact of the most punishing rate rise cycle in modern history will soon send the economy and interest rates sharply lower.

That would help explain why fund managers at present hold their most overweight position in bonds since the aftermath of the 2008 financial crisis, as revealed this week in Bank of America’s monthly survey. Bondholders stand to gain from the high yields on offer as well price gains, if interest rates start moving lower, dragging yields with them.

There is also an expectation that the Fed will cut speedily when it gets going. In 2019, it held the pinnacle of 2.25 per cent for just seven months before easing. Ahead of the 2008 crisis, rates peaked at 5.25 per cent for an unusually long 15 months before being slashed as turmoil spread.

But what if the coming years turn out less like the pattern of peaks followed by sharp reversals that has been the norm in the recent past, and more like the mid-1990s? Then, a swift series of rate rises in 1994 took the Fed’s target from 3 per cent to 6 per cent by early 1995. This was followed by just three cautious quarter-point cuts before a rise again in 1997. That pattern repeated until the dotcom bubble burst in 2001.

“Our sense is that the 1990s is actually a pretty good template for what [the Fed] might do. They may move up and down a little bit as they reassess how restrictive their stance of policy is,” says Marc Giannoni, chief US economist at Barclays, which is forecasting a single rate cut from the Fed in 2024. “If the economy weakens, but inflation stalls at, let’s say, 3 per cent or above. I don’t think [the Fed] is going to be able to ease monetary policy.”

That uncertainty is not good for equity or debt markets much beyond the cheer seen this week. “Everyone is desperate for a rally but stocks and bonds both gaining means that yet again we’ve just eased financial conditions and made the Fed’s job harder,” says Julian Brigden, co-founder and head of research at MI2 Partners. “We still have low unemployment so to squeeze out inflation, we need lower nominal growth — and tighter conditions to get that.”

Powell’s August description of the Fed “navigating by the stars under cloudy skies” attracted some mockery at the time, but it is worth bearing in mind when faced with another bout of markets’ sunny forecasts for interest rates.

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