The rally that has catapulted U.S. stocks into the home stretch of the year to new highs in 2023 could be in jeopardy if the Federal Reserve dashes expectations for interest rate cuts in 2024.
According to Melissa Brown, senior director of applied research at Axioma, U.S. central bankers and investors don't fully agree on when the Fed will begin easing monetary policy.
Traders have also changed their rate cut forecasts in recent months based on Fed funds futures data.
Given the recent volatility, it's not hard to imagine a nervous market environment as investors wait to hear from Fed Chairman Jerome Powell on Wednesday, even though the central bank is not expected to change its short-term interest rate range. Since July, the Fed's key interest rate has been at its highest level in 22 years, between 5.25% and 5.5%.
U.S. stocks rose this year after a turbulent 2022, posting big gains in November as benchmark 10-year Treasury yields BX:TMUBMUSD10Y fell from a 16-year high of 5%. The Dow Jones Industrial Average DJIA closed Friday just 1.5% away from its record close nearly two years ago. The S&P 500 index SPX recorded its highest close since March 2022, according to Dow Jones Market Data.
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“I don't see any report on the horizon that would really convince them [the Fed] “Change their stance on our monetary policy stance,” said Alex McGrath, chief investment officer at NorthEnd Private Wealth. It is largely expectations of Fed rate cuts next year that have supported recent rallies in stock and bond markets, he said.
The Dow Jones closed 9.4% higher for the year through Friday, the S&P 500 gained 19.9% and the Nasdaq Composite rose 37.6% over the same period, according to FactSet data.
“We were a little skeptical about the market's enthusiasm about rate cuts early next year,” said Ed Clissold, chief U.S. strategist at Ned Davis Research.
It will take a gradual process for the Fed to back away from its monetary tightening, Clissold told MarketWatch. The Fed will likely change its tone from very hawkish to neutral, abandon its tightening bias and then talk about rate cuts, Clissold noted.
There were already new signs on the bond market on Friday that investors might be rethinking interest rates in 2024.
Junk bonds JNK
HYG, often a canary in the coal mine for markets, paused after a rally that began in late October as benchmark borrowing costs fell, although the sector has benefited from large inflows in recent weeks.
Treasury yields on 10- and 30-year BX:TMUBMUSD30Y bonds also jumped on Friday, reflecting the volatility that began in mid-October.
Read: Investors have waged a two-year battle with the bond market. Here's what's next.
Mike Sanders, head of fixed income at Madison Investments, was similarly cautious. “I think the market is a little too aggressive in assuming there will be cuts in March,” Sanders said. It's more likely the Fed will start cutting rates in the second half of next year, he said.
“I think the most important thing is that the continued strength of the labor market continues to entrench service sector inflation,” Sanders said. “Right now we just don’t see the weakness we need to address this.”
Friday's U.S. jobs report reinforces his concerns. The government announced on Friday that around 199,000 new jobs were created in November. Economists polled by the Wall Street Journal had forecast 190,000 jobs. The report also showed rising wages and a drop in the unemployment rate from 3.9% to a four-month low of 3.7%.
The Federal Reserve next week will likely “do its best to reject the narrative of cuts coming very soon,” Sanders said. This could be achieved in its updated “dot plot” interest rate forecast, also due on Wednesday, which will provide the Fed's latest thinking on the likely path of monetary policy. The Fed's September update surprised some market participants as it reinforced the central bank's stance on higher interest rates for an extended period.
There is still a chance that inflation will rise again, Sanders said. “The Fed is worried about the inflation side more than anything else. The fact that they take their foot off the brake earlier simply doesn’t do them any good.”
Ahead of the Fed decision, a consumer price index inflation update for November is due on Tuesday, while the producer price index is due on Wednesday.
Nevertheless, seasonal factors could support the stock market in December. According to historical data, the Dow Jones Industrial Average rises about 70% of the time in December, regardless of whether it is in a bull or bear market.
See: The stock market is entering the end of the year with momentum. What this means for December and beyond.
“The overall market outlook remains constructive,” said Clissold of Ned Davis. “A soft landing scenario could support the continuation of the bull market.”
Last week, the Dow posted a gain of less than 0.1%, the S&P 500 edged up 0.2% and the Nasdaq rose 0.7%. All three major indexes rose for a sixth straight session, with the Dow posting its longest weekly winning streak since February 2019, according to Dow Jones Market Data.