Have U.S. Interest Rates Peaked?

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Weekly Market Recap for November 17, 2023

The stock market continued to trend higher this week following Tuesday’s release of the Consumer Price Index (CPI), which showed progress on the inflation front. The release of the Producer Price Index (PPI) followed, showing that final consumer demand declined. This progress may allow the Federal Reserve to be less restrictive with monetary policy.

S&P 500 Index (Last 12 Months)

Bullish and Bearish Market Narratives

Inflation Pressures Ease

Headline CPI was flat in October as gas prices fell and the energy index declined 2.5% m/m. Excluding food and energy, Core CPI rose by +0.2% m/m and +4% y/y, the smallest annual increase since September 2021. All the CPI figures were below forecast, which triggered an equity market rally as the probability of future rate hikes decreased and investors priced in rate cuts. A separate report showed producer prices also declined in October. Headline PPI dipped -0.5% m/m, the most significant monthly decline since April 2020, and PPI slowed to +1.3% y/y from September’s +2.2% pace. The PPI index for goods fell -1.4% m/m as gas prices plunged -15.3%, while prices for services held steady after six monthly advances. The two reports add to the evidence that inflationary pressures are easing.

Inflation Pressures Ease as Energy Prices Decline

Mortgage Rates Decline From Recent Peak

Retail Sales Soften Less Than Expected

Retail sales dipped -0.1% m/m in October, above expectations for a -0.3% drop, but a slowdown from September's +0.9% rise. It was the first monthly decline since March. Control group retail sales, viewed as a more precise measure of consumer spending and used to calculate GDP, rose +0.2% m/m. The data indicates that consumer spending slowed in early Q4 after surging in Q3, but it also highlights the consumer's resilience to higher rates. The looming question is whether the consumer can sustain this spending with the labor market cooling and rates still elevated.

Retail Sales Decline for the First Month Since March

Can the Fed Declare Mission Accomplished?

Investors embraced the inflation and consumer spending data, which suggest the Fed may have pulled off a soft landing by lowering inflation without causing a rise in unemployment. It is premature to declare victory for multiple reasons:

1. The lagged effects of monetary policy have yet to be felt. Unemployment remains below 4%, but it is a lagging indicator.

2. It's difficult to believe that the Fed has perfectly executed and timed this tightening cycle, one of the most complicated cycles in recent history.

3. As we discuss below, there are lingering inflation risks.
   
   

Lingering Inflation Risk

Elevated fiscal spending, ongoing worker strikes, and the long tail of low-interest rates are three macro themes that could keep inflation above the Fed's 2% target. First, Congress passed trillions of dollars in spending in recent years to invest in infrastructure and incentivize manufacturing and green energy investment. Still, only a fraction of the funds have been spent. Second, ongoing strikes and wage increases lock in future wage inflation across industries. Third, consumers and businesses have locked in low-interest rates in recent years and will benefit from low debt service costs, with the October retail sales data highlighting consumers' resilience. This trifecta of high fiscal spending, future wage growth, and sustained consumer strength could underpin strong demand in the years ahead. The outcome could be prolonged high nominal GDP growth and persistent inflation pressures. The rise in inflation expectations in October suggests inflation may already be entrenched.

Interest Rates and US Treasury Yields (Basis Points)

Market Pulls Forward First Rate Cut

Secured Overnight Financing Rate (SOFR) futures, which track Fed funds rate expectations, show investors moved up the first rate cut to June 2024 after this week’s CPI report. The chart below also shows the market now expects three rate cuts by November 2024. It’s an aggressive and overly optimistic forecast. The last mile on inflation will be difficult, especially with the upside risks and the recent rise in inflation expectations. We expect a more cautious approach from the Fed, with interest rates likely to stay higher for longer.

Secured Overnight Financing Rate (SOFR) Futures

Have Long-Duration Rates Peaked?

Long-duration headwinds may be growing. While the early November Quarterly Refunding Auction (QRA) was favorable for bonds, we expect the Treasury to increase bond issuance at the late January QRA, which could weigh on prices. In addition, lingering inflation risk and the market's optimistic rate cut forecast could put upward pressure on rates in 1H24, especially if economic data comes in above expectations. It is possible that yields on the long end of the curve have not peaked yet this cycle.

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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