U.S. investors are bracing for a reality check this week as Federal Reserve officials release updated projections for interest rates. With inflation still persistently above the 2% target, investors are eager to discern whether policymakers maintain expectations for three rate cuts in 2024. The past week saw Wall Street navigating volatility, fueled by new data confirming elevated inflation levels in February. Concerns are mounting among investors who had been pricing in the likelihood of an interest-rate cut by June, as they now fear policymakers may delay such action in light of recent developments.
The upcoming two-day Federal Reserve meeting, set to conclude on Wednesday, is anticipated to maintain the policy rate within a range of 5.25% to 5.5%. All eyes will be on the release of the Fed’s latest Summary of Economic Projections, particularly focusing on the eagerly awaited “dot-plot.” This chart illustrates where individual policymakers envision the fed-funds rate heading in the future.
Thierry Wizman, global FX and rates strategist at Macquarie, suggests that while the Fed may still ease rates by midyear, the upcoming Federal Open Market Committee (FOMC) meeting might extend the wait-and-see approach for another one or two cycles. Powell may reiterate the need for more evidence of sustainable disinflation before considering rate cuts. The recent moderation in disinflation pace may prompt Fed officials to adjust the median “dot” for 2024 and 2025.
At the December policy meeting, policymakers projected a total of 75 basis points in cuts for 2024, with an additional 100 basis points penciled in for 2025. Fed-funds futures traders have aligned with these expectations, pricing in three quarter-point cuts in 2024, down from initial projections of six or seven at the year’s outset, according to the CME FedWatch Tool.
Stocks haven’t seem bothered by hot inflation
So far this year, consecutive hotter-than-expected Consumer Price Index (CPI) reports have brought persistent inflation concerns back to the forefront of investors’ minds. Despite this, the number of anticipated rate cuts has significantly decreased in the interest-rate futures market over the past two months. Surprisingly, the stock market hasn’t appeared to be bothered by these developments.
On Tuesday, the S&P 500 closed at its 17th all-time high following the release of the February CPI report, propelling the large-cap index to a 7.3% year-to-date advance. Similarly, the Nasdaq Composite has seen a 6.4% gain in 2024, while the Dow Jones Industrial Average has risen by 2.7% over the same period, according to FactSet data.
Jimmy Lee, Chief Investment Officer of the Wealth Consulting Group, suggests that investors are becoming more receptive to the notion that higher rates may persist for a while longer. Lee expressed confidence that as long as companies can maintain robust earnings, the impact of higher rates may be mitigated. He anticipates more favorable inflation data in the second half of the year, which could prompt the Fed to adjust its rate projections more swiftly.
While optimism prevails in the stock market, signs of anxiety are evident in the government-debt market. Both 10-year and 30-year Treasury yields experienced their largest one-day advance in a month on Thursday, following the release of February’s producer-price index, which also reported elevated figures.
Neutral rate may creep higher, hurting bonds and stocks
To be certain, what will have the greatest impact on markets is not merely when the Fed initiates interest rate cuts in 2024, but rather the trajectory of rates over the long term.
Thierry Wizman suggested that longer-term Treasury yields could rise further this week if policymakers increase their estimate of the neutral rate or equilibrium rate. Even a modest adjustment of the neutral rate, such as a 25 basis point increase, could potentially exert a significant influence on the 10-year yield.
The neutral rate represents the level at which monetary policy neither stimulates nor restricts economic growth, and it implies that inflation should be at target levels while the labor market remains robust. Although the neutral rate cannot be directly observed, it serves as a guidepost for policymakers in determining the stance of monetary policy.
In December, the Fed’s projections placed the longer-run neutral rate at 2.5%, significantly below the current policy target range of 5.25% to 5.5%. There has been ongoing debate among Fed watchers and investors regarding whether the neutral rate has shifted, particularly as the U.S. economy continues to outperform expectations. If the neutral rate has indeed increased from its 2019 level of around 2.5%, it would imply fewer interest-rate cuts by the Federal Reserve in the coming years.
Wizman suggested that investors may want to exercise caution with bonds this week as the Fed meeting approaches, as heightened apprehension among traders could trigger a selloff in the government-debt market. Additionally, if the Fed raises the long-term neutral rate, it could exert downward pressure on U.S. stocks, particularly with major indices like the S&P 500 and the Nasdaq Composite already hovering near record highs.
The S&P 500 and the Nasdaq Composite experienced their second consecutive weekly losses, declining 0.1% and 0.7%, respectively, while the Dow industrials saw marginal declines for the third consecutive week, according to Dow Jones Market Data.