The Federal Reserve began hiking rates in March 2022, a strategy designed to fight the most intense wave of inflation experienced by the U.S. economy since the early 1980s. Since then, the Fed has lifted its policy rate target from 0.25% to 5.5%.
Investors are wondering when the Fed will loosen its stranglehold. In a welcome piece of news, 10-year Treasury yields pulled back during November. In late October, 10-year yields hit 5%, a sign that investors expected the Fed to continue boosting rates. However, as inflation has calmed and the job market has cooled, bond investors bid 10-year Treasury rates all the way down to 4.4% in late November. This could be a sign that the Fed will begin cutting interest rates in 2024.
Fed policy has succeeded at reining in inflation. The pace of price hikes has eased from a year-over-year rate north of 9% in mid-2022 to 3.2% in October 2023, according to the most recent consumer price index.
Indeed, many observers now say the combination of slowing inflation, a cooling job market and lower Treasury yields are predicting the Fed will pivot away from rate hikes and toward rate cuts in the coming months. Some even say the bond market is forcing the Fed’s hand.
“Based on the weak job number and calming inflation, the bond market is forcing the Federal Reserve to consider lowering interest rates,” said Lawrence Yun, chief economist at the National Association of Realtors, during the group’s annual meeting in mid-November.
Bond markets aren’t the only ones signaling rate cuts. Several central banks in Latin America already have cut interest rates. In Brazil and Mexico, central banks raised interest rates before the Fed moved. Now, those policy makers are cutting rates ahead of American central bankers.
The promise of a rate cut in the near future seems to bode well for hopes that central bankers can guide the economy to a soft landing. Alas, soft landings are notoriously difficult to execute – so it’s best to remain vigilant.
Before investors get too giddy about the Fed cutting rates in 2024, it’s worth noting that any Fed policy pivot is difficult to predict. And even if investors are right about the timing, they could be wrong about the soft-landing scenario.
“Unfortunately, the journey ahead remains treacherous, and both the hard and no landing scenarios remain in play,” said Dario Perkins, an analyst at TS Lombard, according to MarketWatch.
TS Lombard says three possible outcomes remain very much in play. They are:
Hard landing: “Weak demand causes unemployment to rise and reflexivity kicks in while spending and confidence continue to plunge, which, in turn, damages corporate profits and leads to another round of job cuts,” TS Lombard says. “The credit cycle sours, adding another channel for reflexivity. These are the true dynamics of a recession; and when they start, there is massive uncertainty about the ultimate depth and duration of the downturn, which is what kills risk assets.” In this scenario, the economy hits a rough patch, but lower interest rates won’t immediately smooth the bumpy road.
Soft landing: In this hoped-for outcome, the plane that is the global economy touches down smoothly. “Inflation evaporates despite a generally solid macro environment,” TS Lombard writes. “Unemployment is steady or increases modestly, without triggering the reflexivity that defines the hard landing. Central banks either keep interest rates unchanged or deliver a 1995-style ‘midcourse correction,’ taking monetary policy back to a more neutral setting.” In this most sanguine of scenarios, global economies experience a brief hiccup before returning to growth.
No landing: In this scenario, central banks fail to tame inflation. “Far from cutting interest rates, the authorities are forced to continue to tighten monetary policy — perhaps after a brief pause,” TS Lombard writes. “The recession that everyone expects in 2023 is merely postponed because the economy is still ‘overheating,’ with the threat that further policy action will deliver a more sustained (and perhaps more serious) downturn in 2024. Many economists would interpret ‘no landing’ as a ‘hard landing deferred,’ possibly by 12 to 18 months.”
In other words, it’s too soon for investors to breathe a sigh of relief. Markets are likely to remain chaotic and volatile. Uncertainty looms in other corners, too. Wars in Ukraine and the Middle East have introduced wild cards. A contentious presidential election is coming next year.
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