Rate Expectations
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As 2023 started, investors struggled to process the best January on record. An epic January Effect propelled stocks higher despite Q4 2022 earnings reports that were “iffy” at best. The Fed was on a path to the fastest paced increase in rates on record and investors were somehow convinced that rate cuts were on the horizon as early as Q3 of 2023. This is the case despite the Federal Reserve’s best efforts to show investors their plan to not only increase rates, but also for keeping them high for a lot longer than most were predicting. To their credit, Chairman Powell and his colleagues have been remarkably transparent. As we sit today, rates are higher, we may have plateaued, and the rhetoric is still that rates will be “higher for longer”. But once again, investors aren’t listening.
According to The Wall Street Journal and Tradeweb, the interest-rate swap curve suggests that investors are expecting rates to start to decline as early as the end of January of 2024. Needless to say, we’re skeptical as current data suggests that inflation is still well above the 2% target and the Fed is likely to lose credibility if they pull back before that target is achieved. That said, investors are generally logical thinkers, so what gives?
We believe there are a handful of possibilities: 1. The Fed has said there is a possibility of cutting rates without a recession. 2. The most rate sensitive industries need help. 3. It’s an election year.
So let’s walk through those…..In scenario #1, The Federal Reserve Board is well versed in history. In nearly all cases historically, the Fed has overtightened in the face of inflation, and caused a recession. With all the talk of a soft landing over the last 2 years, the current Fed would love to leave a legacy of using data to avoid a negative outcome. It is our belief that they are offering this potential with the hope of avoiding panic. We’re certainly rooting for them, but this type of needle threading is no small task given the lending practices that happened toward the end of the “free money era”. In scenario #2, we have seen weakness in banking, commercial real estate, and big-ticket consumer items like autos. This list is far from exhaustive, but these examples are enough by themselves to put strain on the financial system as a whole. And finally, in scenario #3, investors are cynics, and they should be. Since the S&P 500 was introduced, there have been 24 election years. In those years, the stock market has seen negative returns only 4 times, and two of those years were during the Roosevelt era. While the Federal Reserve is supposed to be independent of the Executive Branch, the President does choose who sits on the board. This means that there is a significant conflict of interest that could dictate who has a job and who doesn’t. Will this Fed give the President a decline in rates to help his campaign? We can’t know for sure, but investors aren’t crazy to think there may be additional pressure coming from that office. Will we see a rate cut in 2024? Perhaps, but we’d be very surprised to see a decline of nearly 100 bp as is currently forecast.
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