Stronger signaling from the Federal Reserve that interest rate cuts are on the menu in 2024 understandably sent both stocks and bonds soaring on Wednesday. I argued several weeks ago for some number of non-recessionary rate reductions next year given the decline in inflation, but markets are now priced for over 150 basis points of policy easing, a scenario that’s unlikely to be stimulative for stocks.
The earnings boom that equity investors appear to be anticipating would require an economy where 150 basis points of cuts are unnecessary, and on the flipside, the world in which we really do get such sharp reductions probably isn’t one where stocks thrive. So, have bond markets rallied too far or equities?
The case for a few rate cuts even without a deterioration in the labor market or pain in financial markets is easier to make now that the Fed has blessed that outcome, with the median Fed member projecting a 0.75% decline in the fed funds rate in 2024 to a range of 4.50%-4.75%. That’s led markets to race ahead. Surely, the thinking goes, the Fed has laid out the bare minimum, and trends in the economic data make a greater number of cuts worth betting on.
But how many more cuts are likely? And would stock investors celebrate an economy that requires the Fed to lower its policy rate by 150 basis points?
The decline in longer-term interest rates since late October has seen homebuilding stocks explode higher. The stocks of the two largest publicly traded builders, Lennar Corp. and DR Horton Inc., have climbed by over 40% since then. Industries related to building materials, real estate brokerage, and mortgage originations have surged as well.
The optimism seems warranted. It’s early days, but weekly mortgage purchase applications have increased by almost 20% already. The current interest rate environment will, in all likelihood, be much better for the business of selling homes, both new and existing, than what we’ve had over the last 18 months.
That, in turn, is likely to drive a pickup in factory orders and business sentiment in the manufacturing industry. The much-followed ISM manufacturing index peaked way back in March 2021 and has been contracting for a year now — a longer period than even during the Great Recession in 2008.
There are many reasons for the slump: the reversal in demand for goods following the pandemic boom, companies allowing inventory to run down rather than building it back up, the pain of inflation, higher borrowing costs, and a lack of visibility on Fed rate cuts.
Between the recent surge in the stock market, the likely resurgence in housing, and greater clarity on policy easing, there’s a good chance we see the manufacturing sector back in expansion mode in the first half of 2024.
So let’s skip ahead and imagine the state of play next spring when the Fed is likely to be lowering rates and trying to decide on how many times to cut. Markets have now fully priced a reduction in March, a timetable that lines up with Goldman Sachs Group Inc.’s recent forecast. So perhaps they signal to markets that cuts are coming at the March, May and June meetings.
By that point most housing market metrics will be showing year-over-year growth, the manufacturing industry will likely be expanding again, and corporate America — particularly companies tied to housing, manufacturing and financial services — will be talking about how the environment has improved.
That isn’t the kind of scenario where the Fed feels the need to cut another three (or more) times in the back half of the year, especially when (for now at least) the mindset is one of “dialing back the amount of policy restraint,” as Fed Chair Jerome Powell explained on Wednesday. In other words, the central bank is aiming for monetary policy that remains somewhat restrictive.
Of course, it’s also possible, albeit less likely, that the housing and manufacturing sectors are less responsive to rate cuts, leading the Fed to deliver on all the policy loosening now priced into the bond market. In that world, much of the stock market rally of the past six or seven weeks seems misplaced. If it takes over 100 basis points of cuts to get the most rate-sensitive parts of the economy moving again, then the economy is weaker than the stock market currently believes.
We’ve seen time and time again how different this economic cycle is from past cycles. It’s encouraging that the inflation data has improved enough to allow the Fed to cut interest rates in 2024, but markets seem to be simultaneously projecting both a boom in the cyclical areas of the stock market and the kind of environment that would drive the Fed to aggressively ease rates.
As things stand the stock market seems to have a better read on what’s likely to happen. The bond market, on the other hand, may be in for a rude surprise over the next several months.
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