The Reality of Interest Rate Cuts: Bad News for Markets


Despite the hopes and excitement surrounding the possibility of interest-rate cuts, it seems that the Federal Reserve is not likely to cut rates as soon as expected. This news is unsettling for the markets.

Wall Street has been celebrating with a bit of a party thanks to the optimism about rate cuts. The S&P 500 has experienced a 15% increase since reaching its low point in late October. One of the reasons for this surge is the moderation in the annual increase of the consumer price index, which has now reached approximately 3% after peaking at over 9% in 2022. This decrease in inflation has led to expectations that the Fed will soon intervene and reduce rates, especially given the 11 previous increases in fed-funds rates since March 2022 that could potentially lead to a recession.

As a result of these expectations, short-term interest rates have already fallen, making borrowing and spending more affordable for both consumers and businesses.

However, there is a significant problem: the economy and inflation are still too strong for the Fed to justify cutting rates within the next few months. Inflation continues to surpass the Fed’s target of 2%. The consumer price index consistently shows an annual percentage gain in the high 3s, indicating that inflationary pressures persist. Moreover, excluding energy and food, the gain in CPI for other goods and services was just under 4% in December, highlighting the severity of inflation in these areas. Even the Fed’s preferred gauge of inflation, the personal-consumption expenditures price index, rose to 2.6% in November, exceeding the desired target.

Despite investors’ expectations reflected in interest-rate futures, where they anticipate six rate cuts this year (a total reduction of 1.5 percentage points), there is a clear mismatch between these expectations and the current state of the economy and inflation. It seems that the Fed will hold off on rate cuts for now, which is likely to result in some disappointment in the markets.

The Outlook for Rate Cuts: A Closer Look

The current state of consumer demand and its impact on prices is a key factor in determining whether rate cuts will occur. While consumer companies are not actively increasing their inventories to boost the supply of goods, there would need to be a further drop in consumer demand for prices to decrease.

Steve Englander, head of North America macro strategy at Standard Chartered, stated that the incoming macroeconomic data does not support a rate cut in March. This suggests that a rate cut may not be imminent.

It’s important for investors to consider the potential consequences of rate cuts. Although the rate of inflation has decreased, easing policy too soon could potentially cause inflation to rise again. Short-term rates, as measured by the yield on two-year Treasury debt, have already fallen from a multiyear high in October. This decrease could stimulate consumer spending, which may conflict with the Federal Reserve’s objective of bringing inflation back to 2%.

The Federal Reserve’s priority, when it began raising rates in 2022, was to cool down inflation, even if it came at the expense of economic growth. Therefore, Thierry Wizman, financial market economist at Macquarie, believes that a Fed rate cut will not occur until mid-year 2024.

If Wizman’s prediction proves to be accurate and Fed policymakers publicly confirm this outlook, it could spell trouble for the markets in the near term. Short-term rates would rise, causing the two-year Treasury yield to increase as well. Consequently, the demand for goods and services would decline, ultimately impacting corporate profits.

Looking at historical trends, it is evident that the stock market index typically gains ground when rates fall and declines when rates rise significantly. Hence, if rate cuts are not on the horizon, stocks that have already experienced substantial growth may need to readjust.

In conclusion, it is still premature to anticipate rate cuts at this time. The overall market outlook suggests that further analysis and consideration are needed before any significant shifts in monetary policy occur.

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