Who's Leading the Way? It's Not the Fed, That's For Sure.
Let's see how the Fed was led by the bond market during a flip-flopping 2024, and what this could mean for the new year.
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If 2024 has taught us one thing, it is that the Fed has been a slave to the bond market.
Now, one assumes central bank policy would lead the way -- instead of playing catch up with a lag. One also assume the Fed would be modelling all the variables to come up with reasonable conclusions about the state of the economy and to devise a sound monetary policy. If that were the case, the Fed would not have shifted from being hawkish most of 2023 to then dovish at the end of last year, only to shift again this summer ... and again toward the past few months.
What's happening? The Fed is being led by the bond market, not the other way around. The bond market was pricing in about five or six rate cuts next year a few months ago, and today it is merely pricing in one or two cuts. Of course, the Fed followed suit in September and then again in December.
Perhaps the most surprising thing is that since the Fed panicked and cut a full percentage point off interest rates since September, the bond market has literally gone the other way: Yields have rallied about one percentage point. U.S. 10-year yields moved from lows of 3.62% to highs of 4.63% this week. The bond market is clearly calling on the Fed's constant flip-flopping and is now convinced the Fed is about to embark on a policy mistake. As it is, President-Elect Trump's policies are seen as quite inflationary, despite his promise to cut federal government spending, which may be difficult if he wants to also lower corporate taxes and deregulate businesses. When one adds the promised tariffs in the mix, one can see why the bond market has been panicking over the last month.
It is well known that the U.S. deficit is out of control, not to mention the plans for harsh tariffs. Investors and portfolio managers are very short U.S. bonds as they expect fiscal discipline to be out of control and the Fed not to stand in its way as its bar to cut rates is a lot lower than its bar to raise rates. The bond market curve has now "un-inverted" entirely, and the big question is whether we see a recession next year, or more worryingly, stagflation as the Fed started cutting rates when the core consumer price index was around 3.3% year over year. The Fed is nowhere close to its target of 2%, nor will it get there unless there is a severe deflation in the world. This is why the bond market has been throwing a tantrum last few months. But will it be that bad?
We can certainly say goodbye to the world of 0% rates and start modelling assets in a world where interest rates are closer to 4%-5%. That is serious rethink in a world that got used to pricing assets at negative rates.
We can certainly say goodbye to the world of 0% rates and start modelling assets in a world where interest rates are closer to 4%-5%. That is serious rethink in a world that got used to pricing assets at negative rates. As back-end rates are sticky, U.S. consumers are unable to re-mortgage their houses or raise debt to spend more as shown by the credit card delinquencies recently. For now, since more than 40% of the S&P 500 index consists of tech stocks, so the focus will be on fourth-quarter earnings. Industry analysts are currently forecasting that earnings will be $243 this year, $275 next year, and $310 in 2026. Forward earnings consensus earnings estimates for the current year and the coming year, rose to a record high $274 during the Dec. 19 week. This has been supporting the S&P valuation for now, despite worries about the economy slowing down or Fed policy.
The market has been choppy, as it has been moving around violently last few weeks since the Fed signaled no more rate cuts unless the data called for it. After the Covid-induced stimulus and spike in markets over the last 4 years, 2025 should prove challenging. The delicate balance between fiscal restraint, strong economic growth and productivity, alongside a restrictive Fed policy is a tall order. For now, the bond market looks extremely undervalued, as a lot of negativity is priced in, especially comparing its 4.5% yield vs. the mere 1.3% dividend yield for equities. It certainly seems a tempting proposition for pension funds to reallocate some funds out of one into the other.
