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Research | 12.11.2023
Bruce Richards Commentary: How Many Dots on the Plot?
The final FOMC meeting of the year is Wednesday, and the question on everyone’s mind is: “How many dots on the plot?”
The market may have advanced too quickly, as its pricing five, 25 bps rate reductions for 2024. My base case assumption is that the Fed’s dot plot will show just two or three cuts in 2024, not 5, and furthermore, the Fed will lower rates in 2024 will be by 75bps leaving the base rate at 4.75% at year-end 2024. What is equally important will be the comments by Chairman Powell. Jerome will likely emphasize the importance of remaining vigilant as bringing inflation down to 2% is his goal. The Fed is data dependent, so if the economy continues to grow above 2%, the Fed will remain firm. In the event of recession combined with lower inflation (CPI report on Tuesday & PPI on Wednesday), then the Fed will be more aggressive with lowering its policy rate. It is still premature to declare victory on inflation, and unknown whether conditions in 2024 results in a soft landing or a recession. We should all take humility in knowing the markets have been consistently wrong about when it comes to predicting the Fed target rate.
Chairman Powell will most emphasize the importance to tighten policy further if it becomes appropriate to do so, however, we all know he will not raise rates further.
Given the deceleration in inflation the Fed can take comfort that it can stay the course, hold rates steady to bring inflation down to its 2% target. Recent data also shows strength in the economy and a reasonably strong employment rate, requiring policy rates to remain unchanged at the current time. So, it’s my view that the Fed Funds rate will remain higher for longer for now, as inflation is stuck in the 3% range for now, and employment is producing over 150,000 jobs per month (unemployment is currently at 3.7%).
Expectations for Interest rates are skewed asymmetrically at the current juncture as treasuries are pricing in aggressive Fed cuts for next year. The bond market has rallied after recent Fed meetings in as it believes the Fed is on a path to aggressively lower rates. This muscle memory leaves the door wide open to reset expectations that the Fed may not move so aggressively. Do you remember the concept that the Fed advanced just a few weeks ago when stating: “the bond market is doing the Fed’s work for it, so further hikes will not be needed”. In a matter of weeks, the 10-year treasury has rallied 75bps, and financial conditions have eased measurably. The irony is that this now makes the Fed less likely to ease sooner as easier conditions are not helping them do their work. The Chicago Fed keeps their National Financial Conditions Index; this index has shown considerably easier conditions in recent weeks compared with the first 10 months of 2023. There are seven inputs that comprise this index including the 10-year treasury rate, corporate credit spreads, and the price level of the S&P 500. Given the huge move in rates and equities since the last Fed meeting, the Fed’s Financial Condition Index shows easy conditions, not tight conditions, therefore the recent market move may require the Fed to remain more vigilant than what it recently assumed to be the case. So, the question is: Are markets overpriced?
My expectation is June 12, 2024, is the earliest the Fed begins to lower its Funds rate, as it will be cautious to avoid stimulating animal spirits for the markets which risks re-igniting inflation.
I expect the treasury yield curve to normalize in 2024. What is normal? Normal is not ZIRP! Normal is not financial repression! Normal is not an inverted yield curve! Normal is not massive QE which manipulates the curve and interest rates! Normal is not a condition we have lived with since the GFC in 2008! It is hard to imagine what a normalized curve looks like, since we had many years of financial repression with ZIRP followed by 525 bp tightening and an inverted yield curve.
As the Fed begins to lower rates, I expect real rates to remain elevated compared to what we have lived with in the past 15 years. Real rates for the UST 10-year should average ~200bp above inflation. When inflations settle at 2%, the 10-year should yield ~4%. Of course, treasuries will rally hard, will overshoot fair value, but Powell wants to return to normal after 15-years of crazy. I expect a normal yield curve to develop, but it will take time and the market will move savagely in the long process to return to normal. When the Fed lowers its rates over the next two years, expect the Funds rate to settle somewhere around 2.5-3% (50-100 bp above inflation). From there, you can construct your normal yield curve by pricing the 2-year note 50bps above the Funds rate and 10-year note 100bps above the 2-year rate. That is what normal is.
For now, the massive rate hikes by Central Banks around the world is history. 2024 will be the year in which Central Banks begin to ease. Europe will move first; its economy is weak and not showing signs of strengthening. This cycle will not be led by the Fed, it will be led by the ECB. Below is the Bloomberg Survey of Central Banks policy rates for 2024 (blue bar):
The market may have advanced too quickly, as its pricing five, 25 bps rate reductions for 2024. My base case assumption is that the Fed’s dot plot will show just two or three cuts in 2024, not 5, and furthermore, the Fed will lower rates in 2024 will be by 75bps leaving the base rate at 4.75% at year-end 2024. What is equally important will be the comments by Chairman Powell. Jerome will likely emphasize the importance of remaining vigilant as bringing inflation down to 2% is his goal. The Fed is data dependent, so if the economy continues to grow above 2%, the Fed will remain firm. In the event of recession combined with lower inflation (CPI report on Tuesday & PPI on Wednesday), then the Fed will be more aggressive with lowering its policy rate. It is still premature to declare victory on inflation, and unknown whether conditions in 2024 results in a soft landing or a recession. We should all take humility in knowing the markets have been consistently wrong about when it comes to predicting the Fed target rate.
Chairman Powell will most emphasize the importance to tighten policy further if it becomes appropriate to do so, however, we all know he will not raise rates further.
Given the deceleration in inflation the Fed can take comfort that it can stay the course, hold rates steady to bring inflation down to its 2% target. Recent data also shows strength in the economy and a reasonably strong employment rate, requiring policy rates to remain unchanged at the current time. So, it’s my view that the Fed Funds rate will remain higher for longer for now, as inflation is stuck in the 3% range for now, and employment is producing over 150,000 jobs per month (unemployment is currently at 3.7%).
Expectations for Interest rates are skewed asymmetrically at the current juncture as treasuries are pricing in aggressive Fed cuts for next year. The bond market has rallied after recent Fed meetings in as it believes the Fed is on a path to aggressively lower rates. This muscle memory leaves the door wide open to reset expectations that the Fed may not move so aggressively. Do you remember the concept that the Fed advanced just a few weeks ago when stating: “the bond market is doing the Fed’s work for it, so further hikes will not be needed”. In a matter of weeks, the 10-year treasury has rallied 75bps, and financial conditions have eased measurably. The irony is that this now makes the Fed less likely to ease sooner as easier conditions are not helping them do their work. The Chicago Fed keeps their National Financial Conditions Index; this index has shown considerably easier conditions in recent weeks compared with the first 10 months of 2023. There are seven inputs that comprise this index including the 10-year treasury rate, corporate credit spreads, and the price level of the S&P 500. Given the huge move in rates and equities since the last Fed meeting, the Fed’s Financial Condition Index shows easy conditions, not tight conditions, therefore the recent market move may require the Fed to remain more vigilant than what it recently assumed to be the case. So, the question is: Are markets overpriced?
My expectation is June 12, 2024, is the earliest the Fed begins to lower its Funds rate, as it will be cautious to avoid stimulating animal spirits for the markets which risks re-igniting inflation.
I expect the treasury yield curve to normalize in 2024. What is normal? Normal is not ZIRP! Normal is not financial repression! Normal is not an inverted yield curve! Normal is not massive QE which manipulates the curve and interest rates! Normal is not a condition we have lived with since the GFC in 2008! It is hard to imagine what a normalized curve looks like, since we had many years of financial repression with ZIRP followed by 525 bp tightening and an inverted yield curve.
As the Fed begins to lower rates, I expect real rates to remain elevated compared to what we have lived with in the past 15 years. Real rates for the UST 10-year should average ~200bp above inflation. When inflations settle at 2%, the 10-year should yield ~4%. Of course, treasuries will rally hard, will overshoot fair value, but Powell wants to return to normal after 15-years of crazy. I expect a normal yield curve to develop, but it will take time and the market will move savagely in the long process to return to normal. When the Fed lowers its rates over the next two years, expect the Funds rate to settle somewhere around 2.5-3% (50-100 bp above inflation). From there, you can construct your normal yield curve by pricing the 2-year note 50bps above the Funds rate and 10-year note 100bps above the 2-year rate. That is what normal is.
For now, the massive rate hikes by Central Banks around the world is history. 2024 will be the year in which Central Banks begin to ease. Europe will move first; its economy is weak and not showing signs of strengthening. This cycle will not be led by the Fed, it will be led by the ECB. Below is the Bloomberg Survey of Central Banks policy rates for 2024 (blue bar):
