The US Federal Reserve has strengthened its pivot language, with chair Jerome Powell’s recent press conference incorporating more reminders of its dual mandate.
This continues a softening in tone that former inflation hawk governor Christopher Waller initiated back in October, when he suggested that rate cuts could be on the table as early as March should the recent supply-driven disinflation persist.
It has, and Powell’s recent language contrasts with 2022 forward guidance, which had sounded increasingly dominated by the inflation outlook.
The timing of rate cuts isn't set in stone, but investors' expectations that rates will indeed come down has led to a strong rally in risk assets, raising the question of what easier financial conditions will mean for 2024’s fundamentals.
This unexpected pull forward in the Fed’s assessment of inflation (from sticky to mission accomplished, subject only to a couple more months of confirmation) alters the conditions under which rate cuts may now occur.
Previously, rate cut expectations appeared conditioned on economic weakening, with an unspoken condition that labor markets soften alongside a decline in inflation.
Now, given recent disinflation – particularly in once-sticky core inflation, thought to be driven most by tight labor markets – the new tone sounds like rate cuts no longer require job weakness as long as the disinflation trend continues.
A critical consideration is the global impact of an earlier Fed pivot, given the Fed’s influence on the world’s reserve currency.If the Fed is correct in its assessment that sticky core inflation has been broken, this opens the door for a more constructive 2024, with the possibility of a strong US economy alongside rate cuts.
Even if economic weakness still appears by mid-year, might markets take this in stride if, instead of needing to wait several months for the central bank to pivot, it already has?
It’s worth noting that the Fed has an institutional culture of safeguarding its independence by avoiding significant policy shifts in the months leading up to presidential elections.
This implies that if the Fed begins reducing rates in the March to June window, versus previous expectations of commencement in the second half of 2024, then this more established trend might allow the Fed to keep cutting rates right through the election.
Global aftermath
Another critical consideration is the global impact of an earlier Fed pivot, given the Fed’s influence on the world’s reserve currency.
Typically, during a Fed-led global easing cycle, the US dollar enters a period of decline as funds shift from hiding in deeper, more liquid markets toward a more risk-seeking posture. That has previously served as the siren song for emerging markets.
A weaker dollar also has often led to rising commodity prices, which tend to be priced in US dollars, benefiting export-oriented countries, particularly those that rely on commodities.
Among developed markets, the current substantial rate differential favouring the US dollar is set to narrow, particularly if the Fed acts before the European Central Bank and cuts rates further. To date, the ECB has not pulled forward expectations for when it might cut rates.
Equity markets and credit spreads have rallied strongly alongside the rates curve due to expectations of lower interest rates. Markets will remain focused on inflation, on watch for several months to gauge support for the Fed’s optimism.
However, sustainable appreciation requires fundamental improvement as well, with margins – the flip-side of the lower inflation coin in some sectors – a key metric to watch.
Should profits inflect higher, while markets look well priced overall, differentiation still appears significant. This offers potential for some of the rally’s laggards to make up the ground on those equities that have performed well.
Michael Kelly is global head of multi-asset at Pinebridge Investments
