Fed dovishness is appreciated by the market
New dot plots, market reaction and analysts thoughts
Fed makes investors’ dreams come true
The Federal Reserve spread holiday cheer through markets. In what was arguably the most-important central bank decision of 2023, Fed officials held interest rates steady for a third meeting and gave the clearest signal yet that its aggressive hiking campaign is finished by forecasting a series of cuts next year. In the Summary of Economic Projections, the Fed removed the one rate hike previously projected and increased the number of rate cuts for 2024 to three, projecting the Fed Fund target falling 75bps to 4.50-4.75% (vs previous projection of 5.0-5.25%) by the end of 2024. The dot plot implied no more hikes and 75bps of cuts in 2024.
Chair Powell declared in his presser that the Fed believes policy is at or near its peak, caveating that the Fed has been surprised in the past and is prepared to tighten policy further if appropriate, said policy will be kept restrictive until the Fed is confident it's on the path to 2% inflation. He noted inflation has eased without a significant rise in unemployment, with the usual caveats that inflation is still too high with a long way to go to target. He echoed his Spelman College appearance by bringing in the line that policy has been moved "well into restrictive territory" into his prepared remarks. Powell still believes more tightening is in the pipeline via lags, saying the full effects of tightening "have yet to be felt". He reiterated prior commentary on the labour market, saying it remains tight but coming into better balance, which policymakers expect to continue, putting further downward pressure on prices. Ahead of Core PCE on Dec 22nd, Powell said the Fed expects a print of 3.1% Y/Y, but added that the Fed thinks it will take some time to bring inflation down to the 2% target. When asked about rate cuts, Powell said they are beginning to come into view and are now a topic of discussion, saying the timing of cuts were also discussed (he said they were not even being considered at the November FOMC). On a soft landing, Powell said he has always felt there was a possibility the economy could avert a recession while inflation came down, and so far that is what they are seeing, saying there is little basis for thinking the economy is in a recession right now.
Traders embraced the dovish message. Stocks rallied, with the Dow Jones Industrial Average and Apple shares both jumping to close at records. The US Treasury market staged its biggest one-day rally since several regional banks went belly-up in March.
The S&P 500 closed 1.4% higher, topping 4,700. “Powell seems to be done taking the punch bowl away,” said David Russell, Global Head of Market Strategy at TradeStation. The preliminary results of an instant Markets Live Pulse survey conducted after the Fed decision had the S&P 500 rallying to 4,877 at the end of next year. That’s a more bullish view than the one reflected in the last poll, before the meeting, when investors expected the benchmark to advance to 4,808.
Treasuries extended an overnight rally, with 10-year yields falling below 4% for the first time since August after the Fed signaled a shift to rate cuts next year. Two bond titans have opposing views on where we go from here — Jeffrey Gundlach predicts benchmark yields will fall to the low 3% range, while Bill Gross thinks the yield is already where it should be at about 4%.
And of course investors are chasing upside. Goldman Sachs:
"Incredibly busy day on the vol desk as calls made up 58% of the tape, one of the highest levels ytd. We saw significant demand for upside with client chasing via single names and same-day options at the index level. With the outperformance in Russel, IWM call volumes stood out with 1.35m on the tape (3rd highest of all time)".
Risk on the downside?
Equity investors may face some hurdles. The S&P 500 is barrelling toward the record high reached back in January 2022, even as real yields are at levels last seen in 2008. The stock market probably needs inflation-adjusted yields, which feed into many valuation models for assets, to come down much further — unless earnings are set to come in stronger than many expect.
Call skew exploding and put skew imploding. Nomura's McElligott adds some colour: "SPX Downside protection is absolutely smashed with no buyers of Hedges in sight."
Some strategists are wary that much of the latest upswing in equities has been powered by the more speculative corners of the market — ranging from unprofitable tech stocks, to regional US banks and battered Swedish real estate. There are warnings that the exuberance might have gone too far. Kiran Ganesh, a multi-asset strategist at UBS Global Wealth Management:
“We’ve seen something of an everything rally and for some parts of the market, the fundamentals don’t really support that”
Valuations and technicals also suggest stocks are vulnerable to a pullback in the short-term. The S&P 500 and Nasdaq 100 indexes have seen their relative strength indicator — a 0-100 gauge of bullish and bearish price momentum — soar into overbought territory, typically seen as a signal that a decline is imminent.
Private equity fund managers are eyeing market bets on interest rate cuts with caution, working instead on the assumption that central banks will keep monetary policy tight, according to Cambridge Associates LLC. Many managers won’t factor in cheaper money for business plans even as traders anticipate lower interest rates in 2024, said Dan Aylott, head of European private investments at Cambridge, which has US$ 569bn in assets under advisement and management. Geopolitical tensions and elections in the US and elsewhere will also create significant uncertainty, he said.
“Macro conditions are still creating headwinds for managers and they have a lot to think about in their existing portfolios”
Street new targets
The market is now pricing in a Fed Funds Rate of 3.8% by the end of 2024, expecting significantly more easing than the Fed's projection of a move down to 4.6%.
TS Lombard's Steven Blitz:
"For a group that prizes the pricing of its policy intentions in the forward markets as being more important to shifting market conditions than the spot rate, they had to know that moving the median forecast for Fed funds at the end of 2024 back to June levels would be a bullish signal".
Goldman Sachs Group economists revamped their outlook for the Federal Reserve, seeing a steady course of interest-rate cuts that begins in March. GS anticipates that the Fed’s preferred inflation gauge — the core PCE price index, which excludes volatile food and energy costs — will slow to 2.1% by the end of next year, effectively meeting the policy-setting Federal Open Market Committee’s 2% target. Goldman is now predicting 25 basis-point rate reductions for March, May and June, with further moves on a quarterly basis. The Wall Street bank previously forecast the Fed to start lowering rates only in the fourth quarter of 2024, with just one move next year.
HSBC sees S&P 500 exceeding 5600 if recession is avoided. Historically, the S&P 500 returns 22%, on average, between the first Fed pause and six months after the first cut – if a recession is avoided. We believe we are in one of those cycles. While growth should slow, we believe the US will avoid a recession. Since the Fed pause in July, the S&P 500 has been roughly flat. History suggests we could see another 20%+ return from now through the six months following the first rate cut (which we expect in 3Q 2024). While upcoming Fed cuts add significant tailwinds for US equities, the US election cycle, slowing economic activity, and earnings growth expectations below consensus temper our enthusiasm a bit.
Fidelty: What's next for stocks?
“With the S&P 500 now trading back at its recovery highs, the valuation math has become somewhat challenging again. The trailing P/E is 22x and the forward P/E is at 20x. That's not terrible, but it’s not a bargain, either. The DCF math requires a formidable Fed pivot, as well as a sustainable earnings recovery, for the valuation to be justified at the current equity-risk premium of 3.9%”.
“We’re having a party,” said Kathy Jones, Charles Schwab’s chief fixed-income strategist.
“In my 2024 outlook I was pretty positive on fixed income for next year. I was thinking we’d get to 4% on the 10-year, three cuts from the Fed, maybe 3.5 with a recession, and here we sit and we haven’t started the year”.
Jeffrey Gundlach at DoubleLine Capital says US 10-year yields will fall toward the low 3% range as the central bank is likely to slash its cash-rate target by a full two percentage points next year. Former Pimco bond king Bill Gross dismissed such euphoria, saying the yield is already about where it should be at just on 4%.
Gundlach:
“We’ve broken down the trend lines and there’s a lot of room below the current 10-year yield level. The economy is going to undershoot the downside and that is going to create a response. We will have to have a lot of money printing.”