Volatility Remains Subdued as Markets Reprice Fed Cuts
In 2023, stocks and bonds rallied in tandem. In the first quarter of 2024, however, the S&P 500 rose 10% marking a new record high, while bonds suffered a modest downturn on markets pricing out rate cuts from the Federal Reserve. The momentum in stocks continues thanks in large part to the halo effect of AI euphoria in mega cap technology stocks. The resilience of the U.S. economy keeps surprising analysts. Income and spending data for February showed consumption remains strong, and U.S. manufacturing activity expanded for the first time since 2022. Inflation is cooling, but not as quickly as many believed. After pricing in over six rate cuts coming into the year, futures markets are now predicting three. This recalibration is helping to drive longer-term Treasury yields to the highest levels this year and complicates the Fed narrative to start their rate-cutting cycle.
Surging commodities pose additional risk to the inflation outlook. Oil prices have broken above $85 for the first time since October 2023 as geopolitical tensions have escalated and demand forecasts are being raised from both industry and consumers heading into the summer travel season. The metals are also suggesting that inflationary pressures aren’t abating just yet. Copper and aluminum are making recent highs while gold is trading at all-time highs. The move in Gold in particular has been predicated on a number of factors with central banks remaining key buyers, and the precious metal being both a haven and rates-proxy trade.
The U.S. dollar has gained against nearly every major peer in 2024. Exchange rates are meaningful because depreciating currencies can drive capital flight as money will move out of a nation with a weak currency in search of higher yields abroad. They can also stoke inflation as declining currencies increase the cost of imported goods. The appreciation of the U.S. dollar has forced other central banks to try and support their own currencies.
If the Fed does, in fact, cut interest rates three times in 2024 as suggested at its last meeting, the rally in small cap stocks from their October low may have more momentum. High yield spreads have continued to tighten from their March 2023 wides, suggesting little sign of market stress. The economically sensitive cohort of stocks has historically outperformed following bottoms in manufacturing, as is being suggested by some of the recent data. In fact, according to Bloomberg, since 1979, there have been 11 periods where ISM manufacturing has dropped to 47. Small caps outperformed the S&P 500 in the year after 10 of those lows.
The corporate credit market remains robust. The spread of investment grade corporate bond yields over Treasuries has dipped below 1.5%. This has alleviated the pressure the Fed and Treasury are putting on corporate balance sheets through high rates and mountains of debt. The longer rates stay higher, the greater the burden for companies that have to refinance. The risk is that lingering high rates eventually create a financial accident. This has not materialized as the first quarter of 2024 has seen high quality corporate debt issuance of $528 billion, up 40% year over year. Lower all-in yields along with M&A funding needs have been met by ample demand.
The Fed’s task is proving to be exceedingly difficult. While economic strength, sticky inflation, and a tight labor market suggest a “higher-for-longer” policy rate, there is a significant bifurcation on main street. The average credit card interest rate is the highest in history at 21%. Credit card balances rose by 15% in the 4th quarter of 2023 relative to the same quarter a year earlier. Recent home buyers are facing high home prices and high mortgage rates with personal spending accelerating and income growth slowing. The personal saving rate reached its lowest level since December of 2022. On the fiscal side the situation appears even more bleak. The U.S. Treasury has now paid an all-time high of $1.1 trillion in interest payments over the last year, almost double the previous all-time high during the onset of COVID. $585 billion was added to the national debt in just the first 3 months of this year, and since the debt ceiling was suspended last June, the U.S. government has borrowed over $3 trillion.
The significant rally in risk assets since October 27th has been founded on inflation falling to the Fed’s target, 6-7 Fed rate cuts, and declining long-term bond yields. Over the last several months, those precepts have largely reversed. So, market participants now face the question of what catalyst will propel markets higher. The Fed and the U.S. economy remain at a crossroads. A reacceleration of demand could trigger a resurgence of inflation, while further deterioration could trigger a recession. Tomorrow’s March employment data provides the next meaningful data point for the Fed in determining their timing and ultimate magnitude in the path of easing.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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