Today's Federal Reserve meeting will answer two obvious questions: Will policymakers end their bias toward additional rate hikes? And how far do they expect to cut rates in 2024? Yet the Fed might also provide an answer to a third question that's off most investors' radar but could certainly influence the reaction of the S&P 500 and 10-year Treasury yield.
Federal Reserve Rate-Cut Odds
Every three months, the Fed shows its cards for how it thinks policy will develop, informed by incoming data. Investors have already shown their cards. Markets are pricing virtually no chance (2% odds) of a rate hike today or at the subsequent Jan. 31 policy update. Markets had been leaning toward a March rate cut, but now think it's a bit more likely the first cut will come at the May 1 meeting. But markets are leaning toward 1.25% worth of rate cuts next year, which would lower the federal funds rate to a range of 4% to 4.25%.
Investor expectations are a critical window for looking at what the Fed meeting statement and new quarterly projections will signal. That's because the dramatic easing in financial conditions since late October has seen the S&P 500 rally strongly to a new 52-week high as Treasury yields pulled back sharply. The Goldman Sachs financial conditions index fell nearly a full point in November, which has an effect comparable to nearly a full point of rate cuts.
With stocks rallying and gas prices easing, the University of Michigan consumer sentiment index surged 13% in early December to a five-month high. That shows the Fed can't totally let its guard down against a reacceleration of consumption and inflation. At the very least, the Fed won't want to provide any extra rope for the S&P 500 and bond market to rally, which would augment the wealth effect while lowering borrowing costs.
Will Fed End Tightening Bias?
Essentially, the Fed has been on the fence between standing pat and one more hike. After Friday's jobs report saw an unexpected fall in the jobless rate to 3.7% and the CPI showed firmer core price pressures, there's some chance the Federal Reserve will keep its tightening bias in place. That would mean reiterating the language in recent Fed meeting policy statements that policymakers will continue to assess "the extent of additional policy firming that may be appropriate" to bring inflation down to 2%.
The other, more likely, option is for the Fed to say that economic risks are now balanced, implying that a rate cut is just as likely as a rate hike. There's good reason for the Fed to shift to a neutral bias. For one thing, it wouldn't really be a market mover, given that Wall Street is already pricing in a likelihood of five quarter-point rate cuts for 2024 and sees almost no chance of a rate hike.
Inflation, Jobs Data
Incoming data also suggests the Fed has made enough progress in lowering inflation and slowing growth to turn the page on rate hikes. Federal Reserve Chair Jerome Powell has said policymakers want to see six months of tame inflation data to be sure that the disinflationary trend isn't fleeting. In the six months through October, both PCE inflation and core PCE inflation ran at just a 2.5% annual rate.
Tuesday's CPI inflation data showed hot core services prices, initially dampening Fed rate cut expectations for 2024. But tame health care services inflation in Wednesday's producer price index, which feeds directly into the late-month PCE inflation report, suggests another month of disinflation. Ian Shepherdson, chief economist at Pantheon Macroeconomics, wrote that he expects just a 0.13% rise in the core PCE price index for November.
Meanwhile, last Friday's November jobs report looked soft below the headline 199,000 hiring gain. Wage growth slipped below 4% for the first time since June 2021. Further, the private sector only added 10,000 jobs outside of health care and social assistance, with 47,000 workers returning after strike resolutions.
How Many Rate Cuts In 2024?
What will the Fed's quarterly projections signal about rate cuts? The September batch of projections forecast just one quarter-point cut from the current level, which would bring the Fed's key rate to a range of 5% to 5.25%. However, those projections came amid the U.S. economy's Q3 surge that saw GDP growth top 5%. With growth and inflation now subsiding, it wouldn't be a surprise to see the Federal Reserve pencil in the same rate outlook for 2024 as it did in June. That would mean three quarter-point rate cuts, leaving the federal funds rate between 4.5% and 4.75%.
Wall Street would likely be just fine with that policy outlook, even though markets are pricing in a full point of rate cuts next year and decent odds of another quarter-point cut. The message would be that the Fed isn't overly worried about a reacceleration of inflation and will be responsive to signs of economic weakness.
If the Fed pencils in just a half-point in rate cuts for 2024, that would signal concern that financial conditions will ease too much. The S&P 500 may react negatively as investors weigh the risk that the Fed will keep policy too tight, putting a recession in play.
The Federal Reserve's Long-Term Neutral Rate
With investors focused on when rate cuts will start and how fast they'll go, the main question seems to be how many slices of cake the Fed will serve. But don't be shocked if a serving of vegetables also winds up on your plate.
The surprise would be if the Fed, in setting the stage for rate cuts, begins to rein in expectations for how low they will eventually go.
Since mid-2019, the Fed's projection for the long-term neutral rate of interest has remained at 2.5%, gradually falling from 4% over the prior five years.
The neutral federal funds rate is one that is neither contributing to faster growth nor restricting growth. It is essentially where the Fed thinks its policy rate will eventually land. Moving this rate higher would literally be moving the goal posts in a way that the S&P 500 might not love, and that might be the intent. Yet there have already been some hints in this direction.
The September batch of projections showed that seven of 18 Fed policymakers now think the long-term neutral interest rate is above 2.5%, up from four in March. It would only take two more to shift the median higher in Wednesday's updated projections. In September, five Federal Open Market Committee (FOMC) members thought the neutral rate was 3% or higher.
In October, San Francisco Fed President Mary Daly, a dove, said that the long-term neutral rate may have risen above 2.5%, possibly as high as 3%.
10-Year Treasury Yield Impact
The Fed has a long way to cut, even if the estimated neutral rate rises. A higher neutral rate of interest certainly wouldn't alter the Fed's rate policy moves next year or even in 2025. That means a higher long-term neutral rate wouldn't mean much for, say, the two-year Treasury yield, but it could raise the floor for the 10-year Treasury yield.
Consider a scenario in which the Fed infers that the long-term neutral rate is now 3%. On top of that, bond investors demand a term premium as compensation for the risk of holding long-term Treasuries. That is becoming more important as federal debt soars, raising the risk that Treasury supply will eventually swamp demand.
If the term premium is 1%, as Sonal Desai, chief investment officer at Franklin Templeton Fixed Income, recently estimated, then the floor for the 10-year Treasury yield is around 4%. That's not far off the current 4.16% 10-year Treasury yield.
The 10-year Treasury yield is arguably the most important interest rate in the world. Not only does it affect the 30-year mortgage rate and auto loans, but analysts use it as the risk-free rate for putting a current value on corporate earnings growth. The Fed probably doesn't want to see the 10-year Treasury yield fall much further in a soft-landing scenario, but it could if investors bet that real interest rates will return to pre-pandemic lows.
Wall Street Eyes Higher Neutral Rate
Raising its estimate of the neutral federal funds rate would be a way for the Fed to push back against the possibility that financial conditions ease too much. Actually, the Fed might be late to the party. Numerous Wall Street economists think the current 2.5% neutral estimate is too low.
Joe Davis, chief global economist at Vanguard, estimates a 3%-3.5% neutral interest rate. The increase has been "driven primarily by demographics, long-term productivity growth and higher structural fiscal deficits," Davis wrote in Vanguard's 2024 global outlook report.
The S&P 500 rose 0.2% in Wednesday morning stock market action, notching another 52-week high as it aims for a fifth-straight gain. The Fed may be starting to worry that the stock market rally will give the economy and consumers a second wind. That could lead the Fed to slow-walk rate cuts, raising the risk of a sharper-than-expected economic slowdown.
Be sure to read IBD's The Big Picture column after each trading day to get the latest on the prevailing stock market trend and what it means for your trading decisions.
