The suggestion that the Federal Reserve will maintain elevated interest rates is wavering after unexpected declines in U.S. inflation figures, much to the delight of stock and bond markets.
In October, the annual inflation rate decreased to 3.2 percent, a significant slowdown compared to 3.7 percent in September, and lower than the expected 3.3 percent, according to the latest U.S. government data on the Consumer Price Index.
Austan Goolsbee, President of the Chicago Fed, encouraged the shift in the market perspective during an event in Detroit on Tuesday. “With declining goods inflation and typically slowly declining inflation for non-housing-related services, the key to further progress in the coming quarters depends on what happens with housing prices,” he said. “We are making progress, but there is still a way to go.”
Market outlook recalculated
The market recalculated the journey ahead. Data from the CME FedWatch tool indicates that the likelihood of a quarter-percent rate hike by the Fed in December has plummeted to just 5.2 percent, down from 25 percent a month earlier. Conversely, the chance of a 25 basis point rate cut in March 2024 has risen from 10 percent on Monday to over 28 percent on Tuesday.
The yield on U.S. 10-year government bonds, which exceeded five percent last month, fell to below 4.5 percent following the inflation report, marking the lowest level in more than a month.
The S&P 500 and Nasdaq Composite ended the trading day with gains of 1.9 and 2.3 percent, respectively. Europe also contributed; the Euro Stoxx 600 rose by 1.3 percent. The U.S. dollar weakened against other currencies, evidenced by a 1.5 percent drop in the U.S. Dollar Index.
Rethinking rate hikes
Amid growing concerns about economic growth, James Knightley, Chief Economist at ING, believes the Federal Reserve gains “the flexibility to respond with interest rate cuts.”
“I wouldn’t necessarily describe it as a stimulus to lower rates but rather a shift in monetary policy to a more neutral position, with the Fed funds rate ending at 4 percent by the end of 2024,” Knightley remarked. Nonetheless, the market consensus remains that a target rate between 425 and 450 basis points is most likely.
Brian Jacobsen, Chief Economist at U.S. Annex Wealth Management, expects Powell to pause interest rates as long as possible. “I anticipate the current pause, which began four months ago, to end in a few months,” Jacobsen stated, foreseeing the first rate cut early next year. He believes investors can now say ‘goodbye’ to rate hikes.
Cyclical cooling
Han Dieperink, Chief Investment Officer at Aureus, also emphasizes that the Fed is nearing the end of a series of rate hikes. Using “hawkish” language, the Fed prevents the market from anticipating imminent rate cuts, he explained, referring to recent statements by Jerome Powell. Dieperink predicts inflation will continue to fall over the next 12 months, reaching the official target of 2 percent in 2024.
“At the same time, we continuously see inflation figures outperforming expectations, and unemployment is starting to rise. These are the two most important indicators for the Fed,” Dieperink commented. “Moreover, it’s evident that inflation will be further suppressed next year as the full effect of the rate hikes is felt. Normally this takes 12 to 18 months, but due to the extremely low rates over a long period, many businesses have financed themselves at low rates for an extended duration,” he added.
“In the long term, interest rates may rise, but first comes the cyclical cooling that depresses rates,” Dieperink concluded. “For the first time in decades, the money supply is shrinking both in Europe and the U.S. Since inflation is always and everywhere a monetary phenomenon, we can now expect disinflation.”
Daleep Singh, Chief Economist at PGIM and former executive at the New York Fed, cautioned. “Given the scars left by the peak in inflation, there’s little to gain and much to lose by announcing the end of the tightening cycle. But the reality is they are most likely done with raising rates,” he told the Wall Street Journal.