As the first quarter of 2024 ends, the US financial markets have dealt with a series of unusual and uncertain events. Federal Reserve policy-outcome prognostications have been valued and revalued by market forces, expressed in futures prices. Stock markets are influenced by the outlook for interest rates, and thus the US stock market reaction function shifts with changes in the forecast of the what the Fed will do and when. The outlook for the Fed seems to range from as many as seven rate cuts to as few as three. The predicted timing of the first cut seems to get continually pushed back as market agents digest incoming data points.
My view continues to be that the Fed will proceed slowly and not engage in rate cutting until it has confidence that inflation is in a solid downtrend towards the sustainable 2% inflation target. That 2% is based on the Personal Consumption Expenditure Deflator (PCE) and related indices. The trend has been downward for months, but a highly confident attainment of the 2% level still seems evasive. In my opinion, the Fed will wait until it “sees the whites of their eyes.” The Fed does not want to be in the position of lowering interest rates and then having to abruptly reverse itself and raise them to fight an intensification of inflation. So, the Fed’s errors will be made on the “go slow” path. Some forecasters now see no rate cuts in 2024. Note that the Fed is simultaneously shrinking its balance sheet and has repeatedly asserted that balance sheet size is a separate tool from interest rate setting policy. I’m not so sure about the linearity of this assertion. We shall find out as the year progresses. Also, note that the Fed is very attuned toward maintaining financial stability and will likely react strongly to any shocks that threaten it.
Electoral politics had little bearing on stock market pricing in the first quarter of 2024. Until the March primaries solidified the candidacies of incumbent president Joe Biden for the Democrats and former president Donald Trump for the Republicans, the markets have ignored the political arena. The focus was on earnings and the earnings outlook, in addition to interest rates. Earnings were generally good enough to keep the market forecasts positive, and the revisions of forecasts were mostly in an upward trend. Some forecasters are now predicting an S&P 500 level above 6000 within a year to 18 months.
Financial markets have mostly ignored the evolving geopolitical risks. I disagree with that opinion by market agents and have maintained an overweighted position in the defense sector in the US Equity ETF portfolio, because we believe that geopolitical risk is rising. I’ve written many times about our fear of the Putin-led Russia-Belarus-Iran-Houthi-Hezbollah-North Korea axis of danger. I believe it is threatening to the Western alliance and the threat is serious. Markets seem more sanguine than I am. Time will tell.
There is change underway in the US banking system, with regulatory issues and the developing proposal to not count a bank’s holdings of US Treasury securities in certain technical ratio tests. Along with that emphasis is the apparent desire of the Fed for the Treasury to increase the proportional issuance of T-bills over T-notes and T-bonds. Fed Governor Christopher Waller has specifically spoken openly about this change. Such a change impacts money markets and the shape of the yield curve over time. This is something that will take months and years to implement as the Treasury shifts its issuance structure of new debt. Simultaneously, the Fed is running down its balance sheet size and trying to shift the balance sheet composition to more and more Treasury securities and declining exposure to its mortgage-backed securities. The Fed would clearly like to eventually eliminate its mortgage-backed security holdings in their entirety. That, too, will take years. These shifts mean changes in the market composition of federally backed securities. Markets must absorb what the Fed doesn’t buy or what the Fed allows to run off, while the market must purchase the replacements and the incremental new issuance. The Fed is certainly not intending to be disruptive and render markets dysfunctional, but it is determined to pursue this longer-range policy shift.
I expect the Fed balance sheet runoff to continue for all of 2024. I expect interest rate cuts to come very slowly, and they may not come at all in 2024 if there is no crisis or shock that creates financial instability.
So, let’s sum this up: (1) little change in interest rates ahead in the second quarter of 2024, (2) more volatility as the political season intensifies, (3) geopolitical risk rising, and a shock could come at any time, or not. Growth of the US economy continues to slow, but recession is elusive, though the risk of recession is rising. IMHO, the biggest risk originates from the political arena and is found in the dysfunctional Congress, especially in the House of Representatives. There risk is high and outcomes are uncertain.
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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.
