Stock and bond markets are getting ahead of the Federal Reserve

It’s too early to start celebrating. That’s the Fed’s sober message, although given half a chance, the markets won’t pay attention.

At a news conference on Wednesday and in written statements after its latest policy meeting, the Federal Reserve did everything it could to curb Wall Street’s enthusiasm.

“It’s too early to claim victory and there are certainly risks” the economy still faces, said Jerome H. Powell, chairman of the Federal Reserve. But stocks rose anyway, with the S&P 500 on the brink of a new record.

The Federal Reserve indicated that it was too early to count on a “soft landing” for the economy (a reduction in inflation without a recession), although that is increasingly the consensus on Wall Street. An early drop in the federal funds rate, the short-term benchmark rate that the Fed directly controls, is also not a sure thing, although Powell said the Fed has begun discussing rate cuts and that markets are, more and more, counting on them.

Markets have been rising since July – and have been positively buoyant since late October – on the assumption that truly good times are ahead. This may turn out to be a correct assumption, one that could prove useful to President Biden and the rest of the Democratic Party in the 2024 elections.

But if certainty was sought about a happy 2024, the Federal Reserve did not provide it at this week’s meeting. Instead, she went out of her way to say that she is positioning herself for maximum flexibility. Prudent investors may want to do the same.

On Wednesday, the Federal Reserve said it would leave the federal funds rate where it is now, at about 5.3 percent. That’s about 5 percentage points higher than at the beginning of 2022.

Inflation, the glaring economic problem at the beginning of the year, has fallen sharply thanks, in part, to those sharp increases in interest rates. The Consumer Price Index rose 3.1 percent in the year to November. That was still substantially above the Federal Reserve’s target of 2 percent, but well below inflation. 9.1 percent peak in June 2022. And as inflation has been falling, a virtuous circle has developed, from the Federal Reserve’s point of view. With the federal funds rate substantially above the inflation rate, the real interest rate has been growing since July, without the Federal Reserve having to take direct action.

But Powell says rates must be “sufficiently restrictive” to ensure inflation doesn’t spike again. And he warned: “We will need to see more evidence to have confidence that inflation is moving toward our goal.”

The wonderful thing about the Federal Reserve’s tightening of interest rates so far is that it hasn’t caused a sharp rise in unemployment. The latest figures show the unemployment rate was just 3.7 percent in November. In a historical basis, this is an extraordinarily low rate and has been associated with a robust, not weak, economy. Economic growth accelerated in the three months through September (the third quarter), with gross domestic product increasing at an annual rate of 4.9 percent. This is nothing like the recession that was widely anticipated a year ago.

On the contrary, with robust economic growth indicators like these, it is not surprising that long-term interest rates in the bond market have been falling in anticipation of the Federal Reserve’s rate cuts. He federal funds futures market On Wednesday, he predicted federal funding cuts starting in March. By the end of 2024, the futures market expected the federal funds rate to fall below 4 percent.

But on Wednesday, the Federal Reserve forecast a slower, more modest decline, bringing the rate to around 4.6 percent.

Several other indicators are less positive than the markets. The pattern of Treasury rates known as the yield curve has been predicting a recession since November 8, 2022. Short-term rates, specifically, for three-month Treasury bonds, are higher than longer-term ones , in particular, for 10-year Treasury bonds. . In financial jargon, this is an “inverted yield curve” and often predicts a recession.

Another well-tested economic indicator has also been flashing recession warnings. The main economic indicatorsAn index formulated by the Conference Board, an independent business think tank, is “signaling a near-term recession,” Justyna Zabinska-La Monica, a senior executive at the Conference Board, said in a statement.

The consensus of economists as measured in independent surveys by Bloomberg and Blue Chip Economic Indicators no longer forecasts a recession in the next 12 months, reversing the view that prevailed earlier this year. But more than 30 percent of economists in the Bloomberg survey and 47 percent of those in the Blue Chip Economic Indicators disagree, saying that there will, in fact, be a recession next year.

Although economic growth, measured by gross domestic product, has been increasing, the first data show which is slowing noticeably, as the impact of high interest rates gradually hurts consumers, small businesses, the housing market and more. Over the past two years, fiscal stimulus from residual pandemic aid and deficit spending has offset restrictive efforts. of monetary policy. Consumers have been spending aggressively in stores and restaurants, helping to avoid an economic slowdown.

Still, a parallel measure of economic growth (gross domestic income) has been running at a much lower rate than GDP over the past year. Gross domestic income has sometimes been more reliable in the short term to measure downturns. Ultimately, the two measures will be reconciled, but in which direction it will not be known for months.

Stock and bond markets are more than eager to end monetary tightening.

The US stock market has already worked its way up this year and is almost back to its January 2022 high. And after 2022, the worst year in modern times for bonds, market returns for the year are now positive for investment grade bonds. bond funds, which track the benchmark Bloomberg US Aggregate Bond Index, which form part of core investment portfolios.

But based on corporate profits and revenues, U.S. stock prices are tight and bond market yields reflect a consensus view that a soft landing for the economy is almost certain.

These market movements may be fully justified. But they imply a near-perfect, Goldilocks economy: Inflation will continue to decline, allowing the Federal Reserve to cut interest rates early enough to avoid an economic calamity.

But excessive market exuberance could alter this result. Powell has frequently spoken about the tightening and easing of financial conditions in the economy, which are determined in part by the level and direction of the stock and bond markets. Too big a rally, coming too soon, could prompt the Federal Reserve to delay rate cuts.

All of this will influence the 2024 elections. Prosperity tends to favor rulers. Recessions tend to favor rivals. It’s too early to make a sure bet.

Without certain knowledge, the best thing most investors can do is be prepared for all eventualities. That means staying diversified, with broad holdings of stocks and bonds. Hang in there and hope for the best.