After the Fed’s Dot Plot surprise in December, markets moved fast to price-in a number of rate cuts in 2024. Perhaps a bit too fast? The jury is still out, with the debate raging as to whether the US Federal Reserve will lower interest rates as fast as the markets anticipate (six times this year) or less.
Markets Don’t “Predict” Interest Rates. The “market implied expectations” tool simply looks at the futures curve and “implies” that if market participants are completely rational actors then, based on their present positioning, six rate cuts are implied. However, anyone who’s actually traded anything even for five minutes in their lives knows that financial markets are the summation of rational expectations, Fear of Missing Out (FOMO), arrogance, herd behaviour, algorithmic trading and some pretty big egos pitted against immense insecurities. It’s not too different to poker really, and like poker, those who master their psychology and use other people’s psychology to their advantage, tend to win out. Bonds, especially, which feature a lot of institutional investors, such as pension funds and central banks, also have an element of significant mandated institutional buying and selling.
So instead of saying “markets predict”, a much more accurate way to put it is that “for the bonds to be fairly valued in the futures market, the Fed would have to cut rates six times”, or simply “futures bond markets are positioned for six rate cuts”. It’s longer, and less SEO-attractive than “markets predict”, but it’s certainly more accurate.
So, at their current positioning, futures bond markets are pricing in double the Fed’s predicted rate hikes.
The Fed can be either data-dependent or forward guiding, but not both. The Dot Plot tool was created at a time of so-called “forward guidance”. It is an internal anonymous survey of FOMC members about where they see rates in the next two years and over the longer term. At a time of Quantitative Easing and forward guidance, an informal commitment of forewarning markets six months ahead of major moves, in a bid to further repress volatility after the GFC. After inflation became volatile, central banks moved towards “data-dependency” i.e., they would act according to the incoming data. As models and data about inflation date back to the 1970s-1980s, a time of Cold War, oil addiction and very different demographics, their dependency can be fairly questioned. And even with that data and hindsight, we can only see averages, and would have to ignore volatility. But a data-dependent Fed doesn’t have the benefit of hindsight and no matter how much it smooths the data out, it can’t ignore inflation volatility altogether. Thus, the approach was more simplistic. If certain indicators point to higher headline inflation, the Fed would be aggressive. Inflation picking up for a second consecutive month could invite a more hawkish stance.
So the move predicting rate cuts has already happened. Whether those actually occur in the summer (less likely because the economy is on a positive path), autumn or winter (more likely) is beside the point for longer-term asset allocators.
Whatever the case we are at the point in the cycle where growth begins to matter at least as much as inflation.
It’s only a question of how much volatility investors can take until valuations catch up to expectations, an all-too-familiar trope of financial markets. In other words, we spend too much time wondering about an issue that will, even if get it wrong, simply put investors through what will at worst be an extra six-month period of higher volatility.
But whereas we know that interest rates will probably come down at some point this year, what we don’t know is when Quantitative Tightening (QT) will stop. Why is that more important? Because QT can hamstring the sustainability of the equity recovery.
For fourteen years, investors knew that Quantitative Easing drove returns for risk assets.
It’s opposite should have the opposite effect, or at least hinder a sustainable bull market.
The Federal Reserve is currently draining c. $80-$100 billion per month from financial markets.
Except for the obvious effect on risk assets, especially for bond yields in an era of significant fiscal expansion, it also sends a signal to market participants to be careful that when they buy an assets, there’s a very powerful seller where there was a very powerful buyer (powerful enough to thin out the market from many a bond trader). And we need to remember that the ECB is contracting its balance sheet at double the pace.
Currently, there’s no word from either as to what the roadmap looks like for ending QT. It could be at the time of the first cuts. After all, it makes little sense to cut rates for the economy but keep squeezing the markets. It could be earlier, as central banks see commercial bank reserves with them dwindling close to the edge of what is their level of comfort. Or it could be later. We simply don’t know yet. And until we do, that’s what we, as investors need to focus on learning.
Interest rates are the trees. The forest is Quantitative Tightening.
