It's All About the Rates

Amid our world of cautionary and jarring breaking news headlines, here is some good news: On January 25, the U.S. Bureau of Economic Analysis reported the U.S. economy grew at a 3.3% annual rate in the fourth quarter of 2023, substantially exceeding estimates by FactSet, the Federal Reserve Bank of Atlanta, and the New York Fed Staff. It is an impressive number driven by strong consumer spending, exports, federal, state, and local government spending, and both nonresidential and residential fixed investment. Additional good news: core inflation, wage inflation, and borrowing costs are all trending in the right direction, too. The following day, we learned the core personal consumption expenditures price index – the Federal Reserve’s preferred inflation measure – rose 0.2% for December and 2.9% on the year, moving closer to its 2.0% target, while the month-over-month annualized for the trailing six months is in line with its target.

Now, some of the not-so-good news: persistent wage inflation, high borrowing rates, a ballooning deficit, $34 trillion in U.S. debt, a housing shortage, dual wars, a border crisis, (let me pause as I catch my breath), and yes, the November election, undoubtedly present challenging headwinds for the global economy. Seemingly ignoring these concerns, the S&P 500 Index notched its fifth consecutive all-time high on January 25, but that streak did end the next day. In general, investors seem more focused on the direction of inflation and interest rates than our ballooning debt and deficit or the geo-political issues at hand. I have said it countless times: the market has this amazing ability to discount the present and look into the future, and right now, investors are gaining confidence the U.S. economy will be better off in the next 12 to 18 months than it is now.

The recent rally began in earnest in late October after the 10-year U.S. treasury peaked at 4.997% on October 23, before starting on a downward trend to close out the year. This reversal in interest rates ignited an “everything rally” that started on October 30 and continued through the end of the year. However, since the start of the new year, the 10-year treasury has moved higher, peaking on January 24 at 4.188% before closing the month at 3.967%, up from 3.886% on the last trading day of December. That move higher to 4.188%, – a modest retracement after the precipitous drop in yields at year-end – was enough to stall the everything rally we saw throughout the final two months of 2023. Despite the recent five straight all-time highs in the S&P 500, most of the major asset classes were down in January, including bonds, small-caps, mid-caps, utilities, real estate, international stocks, and emerging markets. Other than mega-cap tech driving the S&P 500 higher for the month, the rest of the market is trading based on the direction of interest rates.

To simplify this market update: right now, the short-term direction of the markets will be driven by inflation and interest rates, as the market continues to view everything else as background noise.

Jay Powell and the Federal Reserve have given mixed messages on the subject during the last two Federal Open Market Committee (FOMC) meetings (December 12-13 and January 30-31) and in the press briefs following the meetings; yet, the Fed did publish this more refined statement following its December meeting:

“Our actions have moved our policy rate well into restrictive territory, meaning that tight policy is putting downward pressure on economic activity and inflation, and the full effects of our tightening likely have not yet been felt…Recent indicators suggest that growth of economic activity has slowed substantially from the outsized pace seen in the third quarter…If the economy evolves as projected, the median participant projects that the appropriate level of the federal funds rate will be 4.6 percent at the end of 2024, 3.6 percent at the end of 2025, and 2.9 percent at the end of 2026, still above the median longer-term rate.”

The Federal Reserve’s last rate hike (0.25%) was on July 26, 2023, with the next move by the Federal Reserve projected to be a rate cut. Richard de Chazal, an analyst at research firm William Blair, finds that since 1971, once rates have peaked, the Fed has only kept the federal funds rate at that peak for an average of five and a half months before lowering it again. Currently, there is a lot of debate regarding whether the first rate cut will be in March or sometime in the second quarter. The timing of the first cut is not as important as where interest rates will be at the end of the year. The Federal Reserve is projecting two to three 0.25% cuts for the year, while investors, depending on the day (and the data), have priced in five to seven 0.25% cuts for the year. The market will trade off of that gap.

My commentary is straightforward: it is all about inflation and interest rates, and we need inflation to continue trending lower before Jay Powell and the Federal Reserve start the process to normalize interest rates. After the first cut is made, the debate will shift to what will be the new neutral, where fed policy is neither restrictive nor accommodative.

Overall, the core economy is healthy, though the old CPA in me does cringe at our country’s debt and deficit and wonder when that will become a threat to our economy. I have mentioned this before: low interest rates are the gift that keeps on giving – easier to service our country’s debt and great for businesses and consumers. A mortgage today still has a rate more than two full percentage points (about $385 more per month on a 30-year loan for a $300,000 balance) higher than any point from 2011 to 2021.

We need lower rates to return – without adding to inflation – and that is a fickle balancing act the Fed knows it needs to navigate with caution. The Fed and Chairman Powell vocalized this sentiment following the recent January meeting; they expectantly left rates unchanged for January and emphatically reminded us that they need greater reassurance that inflation is approaching its 2% target before they entertain a rate cut. Although the central economy is strong, it is cooling off at the hands of higher rates, as intended – it is the progression of that slowing pace that will dictate when and to what extent the Fed will ultimately lower rates.