Stocks and Bonds Rally After the Fed Pivots

Photo Credit: Aanshu A, Unsplash

Weekly Market Recap for December 15, 2023

The stock market extended its recent rally this week, and investor sentiment continues to be positive, backed by the Federal Reserve Chairman Jerome Powell and the Federal Open Market Committee’s (FOMC) decision to hold the federal funds rate steady at 5.25%-5.50%. An easing inflation trend, as reflected in the Consumer Price Index and Producer Price Index, provided the confidence to hold short-term interest rates at current levels. Most notably, Mr. Powell stated that the federal funds rate could fall to approximately 4.6% by the end of 2024, suggesting three rate cuts of about one-quarter point each.

S&P 500 Index (Last 12 Months)

S&P 500 Technical Composite (Last 24 Months)

November Consumer Price Index (CPI)

The Consumer Price Index (CPI) rose by +0.1% m/m, an increase from the prior month's flat reading but among the lowest monthly readings since 2H20. Core inflation, excluding food and energy, rose +0.3%, compared to +0.2% the prior month. The headline and core readings indicate inflation continues to ease, with the Trajectory chart below showing which categories are driving the decline. Decreases in Used Vehicle and Energy prices have contributed to easing headline inflation and falling Food prices. Core inflation is easing as Shelter inflation, which historically lags due to the long-term nature of leases, inches lower. However, the CPI month-over-month chart highlights the widening gap between core services (ex-Shelter) and core commodity (ex-Food, Energy, and Used Auto) price pressures. While Goods prices are experiencing deflation, Services prices continue to trend higher.

Trajectory of Inflation Across Key Categories

CPI % Month-over-Month - Core Services vs Goods

November Producer Price Index (PPI)

The Producer Price Index (PPI) for final demand held steady, following a -0.4% dip in October. The indexes for both final demand goods and services also showed no change. Excluding food, energy, and trade services, the core index rose by +0.1%, its sixth consecutive advance. However, over the last 12 months, the index only rose +2.5%, the slowest pace since February 2021. The November CPI and PPI data provide fresh evidence that inflation is moving back toward the Fed's 2% target. Our U.S. CPI Leading Indicator agrees, forecasting low and stable inflation in the coming months. However, the indicator has recently underestimated inflation, suggesting inflation could remain stuck around 3%. It would not be enough to keep the Fed hiking, but it could influence the number of rate cuts.

Core PPI Falls to Lowest Level Since January 2021

December FOMC Meeting

As expected, the Fed held rates steady at its meeting this week. The meeting highlights included the Summary of Economic Projections (SEP) and Chair Powell's press conference. The macro-outlook in the SEP was essentially unchanged, except for an additional -0.50% of rate cuts forecasted in 2024. Real GDP growth is expected to dip to 1.4% in 2024 from 2.6% in 2023, with modest increases to 1.8% and 1.9% in 2025 and 2026. Unemployment is forecast to rise slightly to 4.1% by the end of 2024 and remain there through 2026, and inflation is forecast to decline to 2.4% and 2.1% in 2024 and 2025. Despite PCE being forecast above its 2% target, the Fed seems open to rate cuts as it works to bring inflation down to 2%. The December 2024 Fed funds rate projection decreased from 5.1% to 4.6%, an endorsement of 2024 rate cuts.

Initial Jobless Claims Remain Low

Retail Sales Unexpectedly Rise in November

Market Reaction

The Fed's SEP update triggered a swift market rally across nearly all assets, which felt like a short-covering rally after the market was caught off guard by the extent of the Fed's dovishness.

Small Caps outperformed Large Caps, with the Russell 2000 gaining +7.3% compared to the S&P 500's +2.9% return. High Beta was the top-performing factor, with an impressive +8.7% gain. The S&P 500 Equal-Weight factor outpaced the overall S&P 500 Index by +2%, signaling robust underlying breadth. Real Estate surged +6.6% as Treasury yields plunged, with the 10Y yield falling below 4% for the first time since late July. Materials, Financials, Energy, and Industrials gained over 4%, while defensive sectors like Consumer Staples, Communication Services, and Health Care lagged.

Long-duration bonds outperformed as Treasury yields declined, leading Investment Grade to outperform High Yield. The U.S. Dollar Index weakened -1.6% as Treasury yields fell, though the weaker USD didn't lift international stocks, which underperformed U.S. equities. WTI oil rose by +3.3%, while the VIX remained near all-time lows.

Putting It All Together

The Fed is pivoting as it shifts its focus toward a soft landing.

We will consider two styles of rate cuts, with the first style, tied to economic concerns, often triggering more significant and prolonged cutting cycles—such as September 1984, June 1989, January 2001, and September 2007. The second style, termed maintenance cuts, is typically precautionary and leads to shorter and smaller cutting cycles, like in July 1995 as inflation eased and in August 2019 as the Trump administration launched protectionist trade policies.

Unless macro data significantly weakens, an aggressive rate cut seems unnecessary. Based on current data, we believe a -0.75% cut like 1995 and 2019 is more appropriate. However, our concern is that investors, stocks, and bonds already anticipate a rate cut larger than -0.75%. If the Fed disappoints with fewer cuts, there is a potential for stocks and bonds to decline, particularly in 1Q24.

At the same time, today's easing financial conditions lay the groundwork for a potential economic rebound in 2Q24 and beyond—a trend evident across our indicators. As the calendar turns, the financial markets' twists and turns look set to continue in early 2024.

Important Disclosures
This material is provided for general and educational purposes only and is not investment advice. Your investments should correspond to your financial needs, goals, and risk tolerance. Please consult an investment professional before making any investment or financial decisions or purchasing any financial, securities, or investment-related service or product, including any investment product or service described in these materials.

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