The Market Paradox
There is a fundamental inconsistency with the markets as winter turns into spring, or rather as summer turns into fall since we're talking about the US market: deep Fed rate cuts are now priced in, but so is a soft landing. Barely a landing at all, really.
The expectation inherent in prices is that inflation declines, GDP remains reasonably strong, earnings accelerate, credit conditions improve, and the Fed eases aggressively anyway.
This morning's news on PCE (personal consumption expenditure) inflation has more or less locked in the September rate cut - it was steady at 2.5%. "Core" PCE — which strips out volatile food and energy costs — stayed at 2.6%, below the forecast 2.7%.
In other words, Dr Pangloss has sprung from the pages of Voltaire's Candide and declared that "all is for the best in the best of all possible worlds".
Source: Minack Advisors
As Gerard's chart shows, overnight indexed swap (OIS) futures that track Fed funds rate expectations are priced for 250 basis points of easing by the end of next year. Members of the Federal Open Committee aren't far behind, so that's not very surprising.
But is it even possible? Can there be recessionary rate cuts without a recession? That is the key question about what happens in the final four months of 2024.
Usually the sharemarket drifts lower into the first rate cut as earnings forecasts are lowered ahead of the decline in GDP that warrants lower interest rates. This time, the S&P 500 is up 37% in 11 months and the Magnificent 7 are still up 63% after the July correction. Nvidia is up 220%, on which more later.
But this isn't just an AI/Magnificent 7 story, as another of Gerard's charts shows - the Bloomberg 500 minus the Mag 7:
The core problem is that there is now confusion and disagreement about the neutral rate of interest (that's the interest rate that neither stimulates nor contracts the economy—it's not directly observable and can only be guessed at or inferred).
What is it? It used to be 4-5%, but before Covid, it was believed to be 3% (0.5-1% real). Everyone seemed to lose sight of it in the chaos of the pandemic, but it is still thought to be around 3%. That's what Viktor Shvets believes, and who am I to disagree with Viktor?
But the US is apparently having a soft landing with the Fed funds rate at 5.5%, so how can the neutral rate be 3%? That suggests it's closer to 5%, surely.
Time will tell, but the market can't have it both ways - deep rate cuts to 3% and earnings growth simultaneously. And the way things stand, there will be a lot of disappointment whichever of those is incorrect - whether the Fed cuts less than expected or earnings and GDP fall short.
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