Commentary on Political Economy

Friday 15 December 2023



Descending the Matterhorn

The descent has begun. After much debate over the shape of the mountain, the Federal Reserve is preparing to set off down the Matterhorn, and not Table Mountain, with rates now likely to start falling in the earlier part of next year. The Matterhorn is a steep and dangerous mountain, but at least it isn’t a sheer cliff — and even descending from a plateau like Table Mountain is riskier than it seems.

That said, everyone in the market and in the economy had been warned to expect a long hike across Table Mountain. The idea of getting down more quickly is great news in some ways, but introduces more risks. It also raises baffling questions as to exactly why the Fed governors changed their minds so swiftly. Some moderately organized thoughts follow.

Europe Is Out Of Sync

The Fed gave the central banks that had announcements to make on Thursday the optimal cover to move in a dovish direction themselves. They didn’t take it. Norway’s Norges Bank actually hiked. The Bank of England tried to douse expectations for a fall. And the European Central Bank opted to speed up its policy of quantitative tightening (selling bonds onto the market to push up their yields). None did anything greatly surprising, but none opted to take the chance offered them by Jerome Powell and hint at lower rates ahead. 

This leaves market expectations for the Fed and the ECB oddly coordinated. The central banks face different economies, and when this week started this translated into a widespread belief that the ECB would cut first. European growth is far weaker than the US. But after this week’s meetings, overnight index swaps are pricing in more or less identical chances of three 25 basis-point hikes for each central bank by June of next year:

Quite apart from Europe’s slower growth, there’s also the fact that its inflation problem seems to be coming under control rather faster. Core year-on-year inflation (excluding food and fuel) was unchanged in the US in November. In Europe, it continued a sharp fall. Comparing the two, the case for easing looks clearer in the eurozone.

This suggests that the Fed might really be too far ahead of the rest of the world. If that’s true, the dollar should be weaker next year than many had expected — which might in turn be good for assets that benefit from a weak dollar, like precious metals or even cryptocurrencies. 

Why Do This?

If there’s one corner of the economy that could use easier money, it’s the housing market. High mortgage rates have caused activity to dry up, and also made it far harder to sell new houses. That affects the economics of construction. How serious is this problem? According to census data going back more than 60 years, new house prices have never before fallen as much as in the last 12 months:

Mortgage rates are set by the long end of the yield curve (the longest maturity bonds), and so the new message from the Fed has already engineered a very substantial easing. This is what’s happened to the standard Fannie Mae 30-year fixed-rate mortgage benchmark, and the average mortgage rate actually extended to borrowers, as measured by;

The housing market is directly impacted by monetary policy, and so if the Fed fears that it has already squeezed too much life out of it, it makes sense to engineer a rally for longer-dated bonds.

The other most obvious area where monetary policy can have an effect is in the labor market. There are a number of signs that it’s beginning to tighten after the exceptional circumstances of the years after the pandemic, which Powell emphasized in his press conference. Jobless claims are rising steadily, for example, and vacancies are reducing. These suggest that no more hikes are necessary. But if the Fed continues to be focused on the labor market, and much of the research it’s published over the last few years suggests that it is, then there’s also evidence that it’s too soon to start getting people excited about cuts.

The Atlanta Fed’s wage-tracker numbers for November, based on census data, came out Thursday. They suggest that the battle against wage inflation isn’t yet won. Overall wage growth remains above 5%. Perhaps significantly, part-time workers — vital to the services sector, and who have had a brutally bad deal for most of the post-Global Financial Crisis era — are now registering gains in line with the rest of the workforce:

The Atlanta Fed numbers also show that the premium for switching jobs rather than staying has widened once more, another key indicator that the market remains too tight. Add to all this the welter of anecdotal evidence that organized labor is its strongest in more than a generation, with big victories ranging from autoworkers to Hollywood writers and actors, and it’s very strange that the Fed is already declaring victory.

Unusually, the Fed is required to maintain full employment as well as a stable currency. Until now, the rubric has been that price stability is vital to enable full employment. That entailed being prepared to put up with somewhat higher unemployment, something the Fed had said — until this week — that it was prepared to accept. It looks as though maintaining full employment has just been elevated.

It’s possible, to quote Steven Blitz of TSLombard, that “recession isn’t an option.” Unlike Paul Volcker’s time, it looks like this Fed is going to try to avoid a dose of serious unemployment if it possibly can, even at the risk of allowing inflation to take hold once more. Again, this is a change. No Fed governor wants to be compared with Arthur Burns, the chairman who has taken much of the blame for allowing inflation to get out of control in the 1970s. Even Volcker himself made the mistake of declaring victory too early in 1980, and ended up having to hike even more once inflation took hold again. 

It’s also possible that the Fed thinks at this point that it needs to help out those harmed by the collapse of long bond prices. That briefly sparked a full-on crisis for US regional banks earlier this year. Now, the moves in the exchange-traded fund known as TLT, which tracks Treasury bonds of 20 years or longer, suggests that the difficulties for those carrying underwater bonds should just have been alleviated:

And one final point concerns optionality. It’s not long since Powell was saying that by tightening financial conditions, the market was doing the Fed’s job, and thus making it easier not to hike. By engineering this dramatic easing of conditions, Powell makes it easier not to cut. The economy has been given a nice boost (and the proximity of an election may or may not have something to do with it); by doing this now, it’s just possible that it will make it easier for the Fed to resist calls for cuts, and to tighten up if inflation takes hold. 

That’s possible, but it’s a daring and dangerous game if that’s what Powell is trying to do. 


If there’s a risk, it’s that the Fed has repeated the crucial error of 1998, when the meltdown of the Long-Term Capital Management hedge fund and the freezing of capital markets in its wake prompted rate cuts at a time when the economy seemed to need hikes. The result was the biggest melt-up of the stock market in history.

There are significant differences between the post-pandemic world and the much greater optimism of the late 1990s, but there are some crucial similarities. If we take a brutally simple version of equity valuation focused entirely on cold, hard cash, we can compare the yield on three month T-bills (cash) to the dividend yield on the S&P 500. The more the return on cash exceeds that on stocks, the harder it will be for stock gains to be sustained. That ratio is now its highest since the dot-com bubble. As of the middle of 1998, it was exactly where it is now, and began to dip; then came the LTCM bailout and the melt-up that followed:

My thanks to Absolute Strategy Research’s Ian Harnett for suggesting the chart. And if the notion of a melt-up seems implausible, let me offer this extraordinary factoid from the brilliant statisticians at Bespoke Investment Group:

The small-cap Russell 2,000 made a new 52-week high today after hitting a 52-week low just 48 days ago. That's the shortest turnaround time in the index's history to go from 52-week low to 52-week high dating back to the 1970s!

To me at least, that sounds uncomfortably like the lunacy we witnessed in 1999. If there’s a downside to the Fed’s pivot, it’s the risk of a melt-up.

Tearing Up Forecasts

The biggest problem could be confusion. It’s dangerous to scramble perceptions as much as they have been this week. The Fed’s change has been so sudden and so stark that many investors must literally tear up their forecasts and start again.

At the end of last month, Points of Return featured a roundup of the Wall Street forecasts for the end-of-2024 level of the S&P 500. The chart we ran barely two weeks ago appears below, with a new annotation showing where the S&P 500 has closed. US stocks are already where all but the most bullish strategists expected them to be 12 months from now. Either they now go back to the drawing board and publish new forecasts, or live with the fact that they are bearishly predicting a decline next year: 

Yes, this does rather expose the folly of publishing predictions for the next year when there’s still more than a month of the current one to run, a point we made at the time. But the exercise has a serious side. Strategists and asset allocators build their assumptions steadily and don’t expect to have to change them suddenly. They’re going to have to do that now.

And note that it’s not just the stock market that has already galloped through everything that was expected for 2024. Bond market predictions are all over the place, and strategists were already publishing new forecasts on Thursday. The Fed’s pivot was that big a deal. I found the note from Barclays, formally changing their position to expect earlier rate cuts, to be particularly telling:

Our economists have recently revised their expectations for the path of the policy rate and now expect the Fed to start cutting in June 2024 at a pace of 25bp/qtr, with a risk to an earlier start if inflation remains soft. In light of that, we are adjusting our yield forecasts lower. We expect 2yr yields to end 2024 at 3.8% (vs. our prior expectation of 4.2%) and 10yr yields to end 2024 at 4.35% (vs. our prior expectation of 4.5%). 

This means that they expect an uninverted yield curve next year, which would make sense. But it also means that Barclays, even on revised assumptions, predicts that the 10-year yield will be higher in 12 months’ time than its current 3.95%. Even though they’re updating forecasters to account for a newly dovish Fed, they still think the bond rally is “excessive” and has gone too far. 

It’s always dangerous to fight the Fed, so you can expect plenty of investors to chase this rally. But confusion on this scale presents dangers. Rather like a storm or a shower of snow on the descent of the Matterhorn, if your visibility is low and you're not sure where you are, the risk of accidents grows much greater. 

Survival Tips

After lambasting the movie Last Christmas earlier this week, it’s only fair to draw your attention to some good Christmas movies. I think Love Actually is really good and unfairly criticized (a view almost as popular as my ongoing loyalty to U2); It’s a Wonderful Life is evergreen; the original Die Hard is great fun and also introduced Alan Rickman to a newfound status as the ultimate movie villain. There would have been no Severus Snape without it.

But reading The Guardian’s countdown of the top 25, I can only agree with their No. 1 choice: A Muppet Christmas Carol. It has the Muppets, it has Michael Caine, it has Charles Dickens, and it’s fantastic, genuine family entertainment. Do see it this season if you haven't already. And have a good weekend.

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