Contradiction
Is the equity market rally inconsistent with Fed policy?
Bottom Line
While the U.S. economy managed to successfully dodge the recession bullet in both 2022 and 2023, many investors felt that we wouldn’t be quite so lucky in 2024. The consensus theorized that with recession largely inevitable, inflation would soon plunge from its 40-year high in 2022 to the Federal Reserve’s 2% target, prompting the Fed to aggressively cut interest rates six or seven times this year, with the first cut coming at the FOMC’s meeting this past Wednesday.
In sharp contrast, Federated Hermes’ more constructive view on both the economy and monetary policy was decidedly out of step with this bearish consensus. Given the cumulative weight of the central bank’s tightening over the past two years—taking the fed funds rate from zero to 5.5% and doubling its balance sheet to $9 trillion—we expected that sticky, persistent inflation would grind slowly lower over time. As a result, we expect the Fed to successfully stick the soft landing and cut interest rates only three times in the back half of 2024.
FOMC meeting results Fast forward to this week’s policy setting meeting, at which the Fed did not cut interest rates, as we had expected. In addition, the Fed provided us with the quarterly update of their Summary of Economic Projections (SEP), in which they increased their estimate for core PCE inflation this year from 2.4% to 2.6% (compared with 2.8% in January 2024) and left unchanged their 2% inflation target for year-end 2026. Moreover, the Fed reiterated its intent to cut interest rates three times later this year.
Stocks throw in the towel and rally So how did equity investors respond when the Fed demonstrably blew their base case out of the water? The S&P 500 rallied to its twentieth record closing high of the year yesterday, slicing through our full-year 5,200 target like the proverbial hot knife through butter. The S&P 500 is now up 28% over the past five months from an oversold 4,103 on Oct. 27, 2023 to a new intraday record high of 5,261. And it has rallied by 10% so far this year.
At the same time, however, benchmark 10-year Treasury yields have risen on an intraday basis, from 3.78% on Dec. 27, 2023 to 4.35% last week, although bonds have rallied to 4.21% in recent days. In our view, the bond market has done a better job of fully appreciating the dual fantasies of “immaculate disinflation” and an “immaculate pivot” from the Federal Reserve on interest rates.
All that glitters is not gold Amid these cross currents, gold has enjoyed a powerful 23% rally over the past six months, surging from an intraday low of $1,810 per troy ounce on Oct. 6, 2023 to nearly $2,221 yesterday. Such a rally typically signals growing financial-market uncertainty, a slowing economy, rising inflation and an increase in geopolitical risk.
Double-edged sword Given the Fed’s Congressionally authorized dual mandate of full employment and low inflation, Fed officials are trying to concurrently navigate two risks at present. If they cut interest rates too soon, then inflation may become entrenched at a level above their current 2% core PCE target. But if they begin to cut interest rates too late, then they risk increasing the rate of unemployment and slowing the economy, potentially into recession.
Persistent inflation has been choppy lately The nominal Consumer Price Index (CPI) plunged from a 41-year high of 9.1% annualized in June 2022 to 3.1% last November. But over the past three months, retail inflation rebounded to 3.4% in December, fell to 3.1% in January 2024, and then rose again to 3.2% last month. That recent pattern doesn’t provide the Fed with increased confidence that inflation is inexorably declining to target, given upward pressure from housing, energy and food costs and rising wages. Average hourly earnings, for example, rose by 4.3% year-over-year in February, while the Fed needs to see this metric decline to 3% on an annualized basis.
The core PCE (the Fed’s preferred measure of inflation) peaked at 5.6% in February 2022 and has declined to 2.8% in January 2024. But it also rose by 0.4% month-over-month in January, which annualizes to 4.8%. February results are expected at 2.8% and 0.3%, respectively. In our view, the Fed will likely remain in a data-dependent, wait-and-see mode regarding when they begin to cut rates.
Sahm rule triggered? The official rate of unemployment (U-3) leapt to a two-year high of 3.9% in February 2024, up from 3.7% in January and April 2023’s 53-year low of 3.4%. That increase of 0.5% over the past 10 months potentially brings the Sahm Rule into play, which states that if unemployment rises by 0.5% or more on a rolling three-month basis over a year’s time, then the economy typically slows, perhaps into recession. In their SEP update this week, the Fed ticked their U-3 estimate lower to 4.0%.
Soft landing on tap In their recent SEP update, the Fed increased its full-year GDP estimates from 1.4% to 2.1% this year (down from 2.5% in 2023), from 1.8% to 2.0% next year, and from 1.9% to 2.0% in 2026. That 2% trendline GDP growth over the next three years supports the Fed’s economic soft-landing baseline thesis.