Fed rate pivot leaves stocks and bonds with ‘no room for error’

A huge rally driven by the US Federal Reserve’s recent about-face on interest rates has left some big-name fund managers nervous that markets now look highly vulnerable to disappointing economic news.

Stocks and bonds have ripped higher over the past two months, and received a major boost when the Fed dropped its biggest hint yet that it could start unravelling its series of rate rises as soon as next spring. The ascent leaves US equities close to their highest levels on record.

In the short term, that fosters a celebratory mood. But it also means key assets are now priced for perfection — a benign world where central banks chop interest rates back down but without an economic recession forcing their hand. Big investors worry that these assumptions may not match up, and that it would take very little to force a rethink in a year studded with economic, political and geopolitical risks.

“We have an ‘everything rally’ at the year’s end. The magnitude is breathtaking,” said Sonja Laud, chief investment officer at Legal & General Investment Management, the UK’s largest asset manager. “I’m worried about that. There’s no room for error.”

US government bond prices are playing a central role in the late-2023 markets shift. Benchmark 10-year Treasuries have been gaining in price since October, when yields struck 5 per cent — the highest since before the financial crisis. At that point, investors were reflecting the message drummed in by the Fed over the summer that interest rates would stay high for the long haul to drag down persistent inflation.

However, throughout autumn, with inflation falling and signs of cooling in the robust US labour market, the Fed’s message began to shift.

First the central bank suggested that high yields were doing some of its heavy lifting — an acknowledgment that higher borrowing costs were starting to bite. Then officials started to talk about the possibility of cutting rates even with inflation still above target. Yields, which move inversely to prices, sank.

But the breakthrough came at Fed chair Jay Powell’s regular press conference on December 13, when he started to sketch out the potential path towards rate cuts and presented forecasts from other rate-setting officials, pointing to several cuts over the coming year.

Analysts and investors scrambled to catch up, pencilling in rate cuts earlier than they had previously predicted, and in much greater number. Subsequent efforts by Fed officials to cool market exuberance have had little impact.

Swaps markets show some investors are looking for six quarter-point rate cuts next year, against guidance from the Fed for a potential three. Such market measures are not perfect, and could mean that most investors are anticipating two or three cuts but a smattering of hedging for extreme outcomes is bending the median out of line.

Since those pronouncements from the Fed, yields have lurched lower, sinking well under 4 per cent and blasting through many of Wall Street analysts’ forecasts for where they might end 2024. The impact fanned out across other major government bond markets and sent stocks motoring higher.

“What the Fed delivered in terms of message was not a big shock. The market reaction was more of a shock,” said Vincent Mortier, chief investment officer at Amundi, Europe’s largest asset manager. Like Laud at LGIM, however, Mortier was worried that this left both stocks and bonds looking vulnerable. “For the markets to continue to rise needs an alignment of planets that’s very unlikely,” he said.

Some believe the potentially conflicting signals being sent by markets are no impediment to further gains. Days after Powell’s comments Goldman Sachs, which had already set a target of 4,700 for the S&P 500 for the end of 2024, raised that forecast to 5,100, seven per cent above prevailing levels.

“A lower cost of capital should allow stocks with weak balance sheets to ‘catch up’ to the few stocks that have led the market in 2023,” the bank said.

Some fund managers are reluctant to embrace that view, however, in part because of how frustrating trying to make forecasts this year has proved. Numerous times investors unsuccessfully tried to spot a switch in stance on interest rates from central banks still fixated on high inflation. Those efforts “seem a bit ‘old regime’,” said Alex Brazier, deputy head of the BlackRock Investment Institute. “Like we’re going back to how we used to be.”

Investors have also been puzzled by the failure of a widely-anticipated recession, and an associated slide in stocks, to materialise. The accelerating revolution in the use of artificial intelligence pumped up some of the biggest stocks on the planet by market capitalisation, pulling up otherwise lacklustre equity indices.

It took months of persuasion for investors to get the message from monetary policymakers that rates would stay high, particularly after a clutch of US regional bank failures, only for market rates to collapse shortly after the message from central banks had been absorbed.

“The past two years have been a humbling experience for strategists and investors,” said Kevin Gordon, a senior investment strategist at Charles Schwab in New York. “Nobody had a good idea what was going to happen. We’ve had this monster mash-up of prior crises merged into one short period — pandemic, supply chain, inflation, multiple bear markets in multiple sectors. It’s a lot to digest.”

The thorny issue now for investors is the US economy. Equities are anticipating a healthy earnings environment for corporate America while bonds are pointing to a recession. Fund managers have been left nervously watching individual data points, particularly around inflation, that threaten to spark outsized market reactions.

If the Fed cuts rates early, “they will be making a big mistake”, said Mortier at Amundi. “To assume inflation is no longer an issue . . . you can have a remake of mistakes in the past.” The bracingly upbeat reset in markets of late, particularly the drop in bond yields, could even precipitate a resurgence in inflation by stoking cheaper lending, investors warn.

On the flip side, a deep economic downturn could still materialise. “There’s a chance that central banks have pulled this one off, and they have been able to engineer a soft landing, but it’s premature to declare victory,” said Daniel Ivascyn, chief investment officer at Pimco.

“You have to keep two conflicting things in your head at the same time,” said Peter Fitzgerald, chief investment officer for multi-asset and macro at Aviva Investors. He said the Fed could cut rates early in the year but later feel the need to raise them again. “Markets can’t price that,” he said.

The other major source of potential volatility is politics. About 40 per cent of the world’s population will be subject to elections in 2024. The year will start with elections in Taiwan in January — a potentially delicate moment for China’s global relationships. The UK is likely to go to the polls at some point in the year. But many traders see presidential elections in the US in November as the obvious potential flashpoint, especially if Donald Trump prevails in his efforts to secure the Republican nomination.

“If Trump comes in, we don’t know his agenda yet,” said Andrew Pease, global head of investment strategy at Russell Investments. “If he does want to go for growth, he may well be great for equities,” he said.

However, fund managers are wary that elections — particularly in the US and the UK — could prise open cracks in government bond markets.

On several occasions in 2023, investors have proven themselves to be unusually highly attuned to fiscal policy, demanding higher yields even from the US government to compensate for significantly higher borrowing targets. One extreme but unlikely potential outcome for the Treasury market is a sell-off similar to the cratering of the UK gilt market under the brief prime ministerial stint of Liz Truss in 2022.

“I can’t quite see a Liz Truss moment in the US, but I can see the markets getting nervous about a tax-cutting, not-prepared-to-cut-spending Republican populist getting elected,” said Pease.

“The next 12 months would be an area where we would be cautious,” he said. “You don’t make big bets about direction”.

Additional reporting by Nicholas Megaw