December 2023
As the new year kicks off, the bond and stock markets seem to be expecting different outcomes this year. The bond market closed 2023 with a torrid rally that took the yield on the five-year note to 3.8%, down significantly from the mid-October high of nearly 5%. Similarly, stocks, as measured by the S&P 500 closed the year less than 1% away from an all-time high. Seemingly, bond investors view the economy as being on the precipice of, if not already in, a recession; while equity investors seem to be anticipating that profitability is about to reaccelerate. The obvious culprit for the divergence in views is the Federal Reserve’s about-face on interest rates. Prior to the December FOMC meeting, the Fed’s monetary policy had been communicated as “higher for longer” indicating that they were in no hurry to cut interest rates as inflation drifted back to their stated target of 2%. Given that mantra, markets were shocked when the December communique indicated that the committee expected 75 basis point of rate cuts this year. To say that the change in communication was unexpected is an understatement. A quick look at the magnitude of the moves in the two markets is shocking and begs the question, “what has fundamentally changed in the economy?” We answer, not much!
The top tier drivers of the Fed’s monetary policy are stable inflation and steady employment. To balance that dual mandate, the committee looks at both of those measures combined with the trends in consumer confidence, consumption, and home buying.
The Fed has been somewhat successful in reducing Inflation from the sharp spike in prices experienced during 2022. The most recent outcome of 3.1% is well off the 9.1% peak touched in June 2022, but still naggingly above the Fed’s 2.0% stated target. Investors seem to have come to terms that 3% is going to be the new 2%, and low enough for the Fed to adjust interest rates downward.
As the second goal of their dual mandate, unemployment has remained stubbornly low. Previous committees were driven by the concept of a non-accelerating inflation rate of unemployment (NAIRU) and although there was no formula for NAIRU, it was generally assumed to be 5%. That is, if unemployment fell below 5%, inflation was going to be a problem. In recent years, the concept of NAIRU has been abandoned and, in an October 2020 release the Fed published their dual mandate bullseye, showing their target for inflation and unemployment as 2% and 4.1%, respectively. The bullseye included target bands of approximately 1.5% to 2.5% for inflation and 3.8% to 4.5% for unemployment. They have been well outside of those bands for some time. Since the first rate-hike in March 2022, the unemployment rate has barely budged, rising from 3.6% at that time to the 3.7% recorded in December 2023.
With the Fed woefully missing both their mandates, investors should be asking themselves if the recent rally in stocks and bonds is justified and sustainable. We think the answer is probably no in both cases. If the Fed plans to cut interest rates while inflation is above their mandate, they can forget about any further progress in bringing the measure lower. The equity market, on the other hand, can justify the rally in the coming weeks as 4th quarter earnings are released. If earnings grow, the rally should continue. If results show that the consumer is stumbling, a pullback may be in order.
