Financial markets were on a wild ride in the last three months of 2023 and have started 2024 with a good deal of volatility. The root cause has been quickly changing expectations for Federal Reserve (Fed) interest rate policy, with markets increasingly pricing in rate cuts this year. Those expectations are built on evidence of the so-called “soft landing” for the U.S. economy, where economic growth slows yet remains positive, and inflation continues its descent to the Fed’s desired target.
Our growing conviction in the soft landing scenario led to us adjust portfolios at year end, increasing our allocation to U.S. small-cap stocks and bringing overall equity exposure to neutral. But the start of 2024 has been rocky, with some investors tempering rate cut expectations, resulting in stock market declines. We still expect the economy to evolve in a manner that enables, and encourages, the Fed to cut rates. A key factor here will be the level of real (i.e., inflation-adjusted) interest rates, which we see as high enough to achieve the Fed’s goal.
Rate cut bets pared back to start 2024
A lot of ink has been spilled documenting the Fed’s pivot to a more dovish stance at the December 13, 2023, meeting, when the committee’s members recognized they had gotten far too pessimistic about inflation and the median forecast for rates at the end of 2024 fell by 50 basis points, or bps (0.50%). All of that ink is merited but overshadows the fact that markets saw it coming. As inflation data came in lower and labor markets normalized through the fall of 2023, traders grew increasingly dubious of the Fed’s hawkishness, as did we. Figure 1 shows traders pushing down their expected path through the last three months of 2024, ahead of the Fed pivot. This should not be surprising as the Fed often finds itself reacting late at turning points.
The easing of rate cut expectations so far in 2024 is also shown but is mild when taken in full context. It was chiefly driven by yet another strong jobs report, released in the first week of this year. It showed December job growth of 216,000, higher-than-expected wage growth, and a sharp decline in the labor force, all prompting concerns. We still view the labor market as normalizing along the lines of a soft landing, as the report also showed downward revisions to previous months’ job gains. More importantly, in light of strong wage growth, firms showed themselves quite capable throughout 2023 of managing labor cost pressure without pushing those costs onto customers, a feature of U.S. economic exceptionalism that is the centerpiece of our 2024 outlook.
As of January 8, 2024, fed funds futures are showing between five and six rate cuts of 25bps each, translating to a 125–150bps decrease to a rate of roughly 4%. That is a healthy development, as markets had gotten a little too extended late in 2023, fully pricing the first cut by this coming March and pushing as high as seven cuts over 12 months. The paring back early in the year brings the market in line with our view. We expect five cuts, starting with the June 12, 2024, meeting. Importantly, Fed communications would presage those actions, with strong hints likely starting around the March 20, 2024, meeting.
Figure 1: Expectations for rate cuts have been pared a bit to start the year
Federal funds rate and market pricing of future rates (%)