Navigating market exuberance; assessing the divergence between the Fed and market sentiment
Managing Partner, Chairman
Global Head of Corporates
Kennett Square, PA
Market exuberance continued last week as risk-on sentiment continued to take hold on Wall Street. Fed rate cut expectations increased, despite Fed commentary and potential headwinds within the economic data the market is using to calibrate its expectations. The resulting deviation between the market and the Federal Reserve is an opportunity corporations should evaluate.
Headline economic data remains upbeat
Over the past week, economic releases from the Bureau of Economic Analysis provided the Fed with further evidence that a soft landing is possible. Gross domestic product (GDP) was revised upwards, and personal consumption expenditure (PCE) showed inflation continued to cool, which is exactly what the Fed needs to obtain a soft landing. GDP increased to a 5.20% annualized pace relative to an expected 5.00%. Excluding the pandemic recovery, it was the strongest GDP growth in over a decade. Likewise, PCE showed that consumer spending cooled to just 0.10% month-over-month and 3.00% year-over-year. Excluding energy and food, PCE rose 0.20% month-over-month and just 3.50% year-over-year. On an annualized basis, it was the lowest inflation seen since March 2021 for the headline figure and June 2021, excluding food and energy.
Federal reserve officials weigh in on economic data
A variety of Fed officials spoke this week and provided varying outlooks. Fed Governor Michell Bowman was one of the most hawkish and stated, “We will need to increase the federal funds rate further to keep policy sufficiently restrictive.” She was joined in her hawkish stance by Fed President Thomas Barkin. Meanwhile, their counterparts including Fed Governor Christopher Waller, Fed President Raphael Bostic, Fed President John Williams, Fed President Mary Daly, and Fed President Loretta Mester, all indicated that the downward trajectory of inflation in combination with a restrictive policy rate meant they would likely be in support of holding rates steady at the upcoming policy meeting. Notably, none mentioned supporting potential rate cuts.
Federal Reserve Chairman Jerome Powell also spoke this past week and pushed back on any potential rate cuts by stating, “It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease.” He also left the door open for additional hikes by stating, “We are prepared to tighten policy further if it becomes appropriate to do so.” Despite his commentary, the market interpreted his speeches as relatively dovish due to his choice of wording. He noted policy was “well into restrictive territory”, whereas previously he did not use the words “well into.” He also indicated that the risk of doing too much hiking in response to inflation is now roughly even with doing too little, whereas previously he described the risk of doing too little as far more concerning.
Markets react to upbeat economic data and Fed commentary
Despite members of the Fed cautioning against it, the market interpreted the Fed commentary, GDP strength, and cooling inflation as an indication that rate cuts were imminent. According to CME futures and represented on the graph below, the market now predicts the first fed funds rate cut by March. The market also expects a 400–425.00% Fed Funds rate by December 2024, which is a full 50 basis points lower than prior week's projections.
Based on the summary of economic projections released by the Fed in September, Fed officials expect the December 2024 Fed Funds rate to be between 4.50–4.75%, which is 50 basis points higher than the current market prediction. The next update from the Fed will be provided on December 13.
In response to an expectation of faster rate cuts, the S&P 500 rallied last week and treasury yields fell. The S&P 500 closed Friday, just 4.40% away from its all-time high. Meanwhile, the 10-year Treasury closed Friday with a yield of 4.206%, which was over 26 basis points lower than it was the prior week. It was the lowest level seen since early September. Likewise, the two-year Treasury closed Friday at 4.551%, which was over 40 basis points lower than it was the prior week. It was the lowest level seen since early August.
Delving deeper into economic data reveals risks remain prevalent
Despite the euphoria on Wall Street, risks remain ever-present within the economic data. GDP data showed just 0.38% of the 5.16% increase came from business investment and net exports. The rest came from government spending (0.94%), inventory build-up (1.40%), and consumption (2.44%).
The consumer outlook continues to deteriorate. Credit card debt hit a record $1.08 trillion in September, and consumers are struggling to pay it down. According to the New York Fed, 8.01% of credit card holders are at least 30 days past due, and 5.78% of credit card holders are considered seriously delinquent — the highest levels seen since 2011 after the Great Recession. There is also increased delinquency in car loans, with 7.39% of auto loans now 30 days past due and 2.53% of car loans seriously delinquent, also the highest levels seen since 2010 after the Great Recession. The deteriorating consumer threatens the continued economic recovery, which could be causing increased inventory build-up. Likewise, the GOP continues its push in Washington to reduce government spending, which threatens GDP as well. With all three in mind, it’s no surprise that GDP, according to a Bloomberg survey of banks, is expected to be just 0.30–0.40% on an annualized basis in both the first and second quarter of 2024.
Inflation, the other pillar of this week’s data, could also run into headwinds in 2024. Although the declines have been welcome news for the Fed, there is a chance that housing inflation will continue to put upward pressure on inflation. Housing inflation contributes about 17.00% to core PCE — the Fed’s preferred gauge — and about 34.00% of CPI, which consumers often pay close attention to. Housing inflation has increased over 6.00% for both indexes in the last year. That represents over a 2.00% increase to headline CPI and a 1.00% increase to core PCE, regardless of all other inflationary pressures. With housing affordability at an all-time low since 1986 — according to The National Association of Realtors, and the residential rental vacancy rate at 6.60%, below the 30-year average of 8.18% according to the U.S. Census Bureau — rental price increases and housing inflation could make it increasingly difficult for inflation to continue its decline and for the Fed to cut rates as early as the market predicts in 2024.
Considerations for corporations
As a result of market exuberance, the market is again starting to significantly deviate from Fed projections for the path of future interest rates. As a result, swap rates and caps have fallen dramatically over the past few weeks. For instance, relative to mid-November, the cost of a two-year, one-month USD-Term SOFR, $100 million interest rate cap at a 4.50% strike has fallen by 36.00%, or $521,500, to a cost of $916,500 as of Friday’s close. Likewise, a five-year, one-month USD-Term SOFR, interest rate swap has fallen by 49 basis points since mid-November to 3.79% as of Friday’s close.
Corporates should keep the potential headwinds for both GDP and inflation in mind as they evaluate the current market. The increasing deviation between the Fed and the market for the future path of interest rates could create a favorable hedging opportunity for corporations.
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