Investors Still Are Misreading the Fed

For at least 15 years, investors erred when anticipating the Federal Reserve’s actions, and they’ve done it again.

Futures markets tell us what investors anticipate. In 2021 and early 2022, interest rate futures indicated the Fed would cut rates. Yet, in 2022, the Fed executed the fastest increase in interest rates in at least 40 years.

At the start of 2024, investors seemed to expect the Fed to cut rates at least six times during the year for a total rate reduction of more than two percentage points.

As the first economic data of the year was issued, investors realized their error. Futures markets recently forecast the Fed would cut rates only three times in 2024 for a total one percentage point decline.

A consequence of the adjustment to reality is that the long-term treasury bond exchange-traded fund (ETF) is down almost 5% so far in 2024.

Even after the adjustments, the Fed isn’t likely to ease monetary policy as much as the markets expect.

The main case for interest rate cuts is that inflation is well below its 2022 peak and slowly moving toward the Fed’s target. Fed officials have indicated they might ease monetary policy even before inflation hits the 2% target.

Also, the Fed is implementing a stealth easing without cutting interest rates. It scaled back its quantitative tightening policy in which it reduces its balance sheet by not replacing some bonds and mortgages that mature.

The Fed is replacing more of the maturing securities than it was through most of 2023. That increased the monetary base and helped boost stock and bond prices in late 2023 and early 2024.

Yet, there are multiple reasons the Fed won’t ease as much as the markets currently expect.

The economy continues to grow at a healthy clip, especially in the service sector.

While there has been some weakening in the labor market, unemployment remains low, job growth is solid, and wages are increasing at least as fast as inflation.

That’s why consumer spending continues to increase, and many businesses remain focused on growth and doing what it takes to retain workers.

The greater risk for the Fed is that it eases too soon and reignites inflation. The economic data give the Fed no reason to worry about a recession or even stagnant growth.

While many investors want interest rates to return to near zero, the Fed has always viewed that level as temporary. It wants interest rates to settle close to the historic average.

Despite the easier Fed policy, there aren’t many reasons to expect strong returns from financial assets in 2024.

Stock index valuations remain near historic highs. With little margin of safety, stock prices are sensitive to even minor disappointments in the economy, earnings, interest rates and inflation. Today’s yields on risk-free assets are tough competition for highly priced stocks and bonds.

Two other factors should be on your radar screens.

China is having a bout with deflation and economic growth that is slow by its pre-2020 standards. While the government is taking some actions to improve conditions, it is less focused on growth than in the past. Slow growth in China hurts Asia and much of the global economy.

International conflicts are another concern. Markets didn’t react much to the Russia-Ukraine war or the events in Israel and Gaza. Investors seem to believe both the political and economic consequences will be contained. A surprise here could spark a flight to safety by investors.

There aren’t a lot of reasons to think a significant bear market is imminent. There also aren’t many reasons to expect strong returns in U.S. stocks and bonds. We need to be cautious, because a few changes in trends could cause stock prices to tumble.