Commentary on Political Economy

Tuesday 19 March 2024




Today’s Points:

Ahead of the Fed, Yet Again

Not long ago, money markets were priced on the assumption that a rate cut from the Federal Reserve this month was a total certainty. Now, as the Federal Open Market Committee convenes for its spring meeting while Washington’s cherries come into blossom, that’s changed. Nobody thinks that rates are going down yet, while money managers are back to thinking that the greater risk is overheating — which would imply a risk of more inflation and greater interest rates to keep them in check.

So after several months when the Fed and the markets were out of line, as investors expected far more aggressive cuts than the central bank had ever intimated, it looks like a role reversal is underway. That comes through clearly from the latest Bank of America Corp. monthly survey of global fund managers. 

In January, fund managers were worried about geopolitics and the possibility of an economic hard landing, a natural environment to expect rates and inflation to come down. Now, their biggest concern, by far, is higher inflation. That psychology in itself may make it harder for the Fed to cut aggressively. This also came through when managers were asked to place their bets on the chances of “no landing” — the popular term for an economy that surges on strongly and makes it harder to cut rates — or a soft or hard landing. The chance of no landing is up from 3% in June to 23% now. Odds of a hard landing are now 11%, having been as high as 30% last October:

A final startling data point is that two-thirds now describe a recession within the next 12 months as unlikely. That’s the highest since the Fed’s rate hikes began early in 2022:

Fund managers are now quite a long way ahead of the bond market, where recent rises in shorter-term yields have kept the yield curve deeply inverted. In other words, we remain in the unusual position where yields on shorter-term bonds are higher than longer-term. This makes life difficult for lenders, and implies a belief that rates and inflation will be lower in future — which in turn implies a weak economy. The New York Fed’s recession indicator, which derives the implicit chance of a downturn within the next 12 months from the yield curve, still shows a two-in-three chance of recession, even as two in three fund managers are comfortable that one can be avoided:

Higher rates wouldn’t be great, but they’d be far worse for bonds than stocks, which could at least prosper on the higher revenues generated by companies in a strong economy. So fund managers, and the stock market as a whole, are engaged on an ambitious bet that the bond market has it all wrong, the economy will keep surging, and so stocks will beat bonds. The risk is recession, which the bond market now deems far more likely than the mass of money managers. If the economy slows down, that would be the classic time to hold bonds.

Comparing the performance of the biggest exchange-traded funds tracking the S&P 500 and Bloomberg’s index of 20-year or longer Treasury bonds (universally known by their ticker symbols SPY and TLT), there were a few months at the end of 2023, as the Fed prepared the way to pivot from higher rates, when bonds at last managed to outperform. Those have now been more than canceled out as the S&P reaches new highs relative to bonds:

Staying with stocks, one final note of caution that might almost be bullish: BofA was moved to inquire directly whether artificial intelligence stocks were in a bubble. As everyone else is asking that question, it made sense. And it turns out that the managers of big money are as clueless as the rest of us. They split almost exactly down the middle:

To put a negative spin on it: More than half of the world’s biggest money managers can’t say that this isn’t a bubble, so this is obviously a matter of great concern. In a positive spin, if that many people think it’s a bubble, it’s hard to believe that it is. There’s still a nice big wall of worry to climb, and many more bulls to capitulate, before it bursts. 

There’s little point speculating about exactly what the FOMC will say at this late stage. But it’s quite a popular prediction that the “dot plot” of different members’ predictions will show that the median number of projected rate cuts this year has dropped from three to two. It looks as if the market could live with that. If Jerome Powell gives another of his surprise dovish turns, that could fuel the rally yet further. Let’s just hope the yield curve has this wrong.

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