By A growing contrarian perspective has emerged challenging the recent optimism surrounding the Federal Reserve’s ability to combat inflation without causing a recession or significant rise in unemployment.
The central idea is that the Fed’s unexpectedly dovish pivot, with plans to implement three quarter-point rate cuts in 2024, may inadvertently undermine their battle against inflation and create a new set of challenges. This shift in policy is reviving the market psychology known as “animal spirits,” instilling investors with greater confidence and easing financial conditions. However, this may complicate the task of controlling inflation.
The resurgence of these “animal spirits” poses the greatest risk resulting from the Fed’s policy update. Officials are striving for an economic soft landing by endorsing a more proactive approach of implementing a series of cuts. Charlie McElligott, a cross-asset strategist from Nomura Securities International, highlights in his post-Fed update note that financial conditions are becoming less restrictive, despite the historically tight labor market. Moreover, both households and corporations are benefitting from the positive wealth effect stemming from a rising stock market and favorable interest rates on cash-like investments. The combined impact of these factors could lead to sustained consumption and stimulate inflation, thereby potentially necessitating a future policy tightening.
The market response to the Fed’s preemptive pivot could be seen as a “QE/portfolio-rebalancing channel trade,” according to McElligott. He has been consistently cautioning about the risks associated with the reemergence of “animal spirits” for several months now.
The “Everything Rally”: An Unfading Phenomenon
As the “everything rally” continues to dominate the market, experts are weighing in on its potential implications. According to renowned market strategist, McElligott, there is currently no need to attempt to fade this phenomenon. He believes that fading the rally would only be necessary if inflation and economic growth were to reaccelerate or in the event of a “hard-landing” scenario where the labor market cracks, requiring significant interest rate cuts.
McElligott’s sentiments are echoed by the investment team at Northwestern Mutual Wealth Management Co. They anticipate that completely snuffing out inflation will be challenging and anticipate policymakers being hesitant to cut rates until it sustainsably returns to 2%. Consequently, they predict that in the absence of a perfect economic landing, certain investments such as small- and mid-cap stocks will outperform others in the next 12 to 18 months.
Recent remarks made by New York Fed President John Williams further add credence to the skepticism surrounding a dovish pivot by the central bank. Williams emphasized that officials are not currently discussing rate cuts.
These developments have had mixed effects on the market. Initially, Treasurys experienced a sell-off due to Williams’ comments but eventually stabilized, resulting in slightly higher to unchanged yields by the end of the day. Meanwhile, the three major stock indexes (DJIA, SPX, COMP) displayed a mix of performance levels during Friday’s afternoon trading session. Despite the uncertainty, traders in Fed fund futures still anticipate the likelihood of five to seven quarter-point rate cuts next year.
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