Has Christmas come early?

TRADERS’ RISK CALL 14 Dec 2023

This week, we discuss the following:

In December’s Federal Reserve meeting, the Fed stunned markets when they projected 3 interest rate cuts for next year. As a result, risk assets rallied and USD weakened. Vee explains his thoughts behind this shift in the Fed.

Transcript:

Today we’ll be discussing the Federal Reserve meeting that just happened. There have been very significant developments. From the FOMC meeting yesterday, we learned that the Fed has kept interest rates unchanged as expected, and most of the statement remained unchanged as well. However, the big surprise came after, in the Summary of Economic Projections, commonly known as The Dot Plot. The market was caught off guard as they pencilled in three interest rate cuts for next year, totaling 75 basis points. Previously, they were projecting only one cut in the September projections, so this was a significant shift, acknowledging the need for substantial cuts given the current outlook.


We are not in a recession yet; the economy is still growing strongly, and markets are robust. They are now projecting three interest rate cuts next year, bringing the policy rate to around 4.6% by the end of 2024, then to 3.6% by 2025, and finally to 2.9% in 2026. The long-run projection for interest rates is 2.5%. Of course, as it goes further out, the likelihood of this being accurate diminishes, but it’s important to note their acknowledgment of the need for rate cuts next year.


They also added a keyword into the statement. It reads, “In determining the extent of any additional policy firming that may be appropriate to return inflation to 2% over time.” Previously, they just said “extent of additional policy firming,” so the addition of “any ” suggests that more additional policy firming is likely appropriate, but it’s only a matter of how much more is required.


The Fed Chair also started off his press conference by stating that they stand ready to raise interest rates if required but also acknowledged for the first time the possibility of interest rate cuts. This is a critical point: when they first embarked on this hiking cycle, they were addressing the question of how fast they could move. They moved quickly at the beginning, hiking rates in 50-75 basis point increments. As they proceeded, they had to consider how much more was required, leading them to slow down this year, both in pace and increment size.
The next discussions will likely revolve around how long they should maintain higher rates and when they should start cutting. For the first time in this policy meeting, they have openly discussed interest rate cuts, which is likely going to be a focal point in next year’s meetings. Most members now expect rate cuts going forward; it’s just a matter of how many. They also indicated that they are likely at the end of the interest rate hiking cycle.
An important point to note is the inflation forecast. They revised it quite aggressively. Previously, they expected it to be around 3.3% for this year, but now it’s projected to be around 2.8%. Next year’s projection is 2.4%, slightly lower than the previously expected 2.5%. The core PCE inflation, their preferred measure which strips out volatile components like energy and food prices, is expected to be 2.4% next year, down from the previous estimate of 2.6%. This is much closer to their 2% target.


Interestingly, at one point in his press conference, the Fed Chair noted that they would start cutting interest rates without seeing actual inflation at 2%, acknowledging that inflation tends to overshoot. They do not want to hold on too late, as that could lead to inflation dropping too low, potentially to 1% or even lower.

Regarding the question of when they would consider cuts more publicly, the Fed Chair was reluctant to give a specific number, emphasising their focus on the overall picture and their data-dependent approach. He also mentioned that risks are now much more balanced, and they are in a position to address both mandates: full employment and price stability. Inflation, although still elevated, has come down significantly.


The market reacted as expected, with the Dow Jones Index closing at all-time highs, surpassing even the pre-rate hiking cycle highs. The Nasdaq and S&P are also very close to their all-time highs. This trend is likely to continue, especially with moderating inflation.


The committee members were able to stretch their Dot Plot forecasts as late as after the PPI numbers were released yesterday, incorporating these into their forecasts. This shows that inflation is going lower and at a faster pace than expected.


Overall, it’s a very dovish Fed. They acknowledge that inflation is surprising them to the downside, and they believe that the moderation in economic growth and the jobs market is bringing all these risk factors into balance. They are now in a position to consider cuts as lower inflation will mean higher real interest rates, potentially slowing the economy further.


We believe this is the end of the hiking cycle. Risk assets will start to perform even better towards the end of the year and as we turn to the new year. As always, stay true to the process, and you will eventually be profitable. Thank you. Cheers.