Way back in 1968, British rock band The Who penned one of their more memorable (but by no means best) songs, titled “Magic Bus”. When I look at what is driving markets, I can’t help but improvise the lyrics (and you’ll pardon me for doing so, but at least you can’t hear me sing):
“Every day we get in the market queue (Too much, Market Bus)
To get on the bus that takes me to you (Too much, Market Bus)
So many riding, nothing but smiles (Too much, Market Bus)
The market says the pivot is only another mile (Too much, Market Bus)
Thank you, Fed, for getting us here (Too much, Market Bus)
You are helping the market have no fear (Too much, Market Bus)
I don’t want to cause no fuss (Too much, Market Bus)
But who is driving the Market Bus?”
The market continues to be singularly focused on the Federal Reserve (“Fed” or “FOMC”) pivoting to lower rates, along with the asset valuation support and tailwind it is expected to bring. To this I can only say “Who’s driving the bus?”
The following table shows the change in expectations from the November FOMC meeting (November 1, 2023) to December 15, 2023:
Which can be shown graphically here:
While this may not seem big given the size and speed of the Federal Funds (“Fed Funds”) increases we’ve seen over the last 18 months, it flies in the face of Fed speak:
- Federal Reserve Bank of Chicago President Austan Goolsbee (12/18/23, CNBC): "I was confused a bit ... was the market just imputing 'Here's what we want them to be saying.' I thought there seemed to be some confusion about how the FOMC even works. We don't debate specific policies speculatively about the future," and "It's not what you say or what the (Fed) Chair says, it's what do they hear and what do they want to hear?"
- Federal Reserve Bank of Cleveland President Loretta Mester (12/18/23, FT): “The next phase is not when to reduce rates, even though that’s where the markets are at,” Mester told the Financial Times in an interview. “It’s about how long do we need monetary policy to remain restrictive in order to be assured that inflation is on that sustainable and timely path back to 2 percent.” “The markets are a little bit ahead,” she added. “They jumped to the end part, which is ‘We’re going to normalize quickly’, and I don’t see that.”
- Federal Reserve Bank of Atlanta President Raphael Bostic (12/19/23, Atlanta luncheon): "I’m thinking inflation is going to come down relatively slowly in the next six months, which means there’s not going to be urgency for us to start to pull off of our restrictive stance."
And that is just the last few days. What gives?
The content from the last (12/13/23) set of FOMC materials shows us that the FOMC shifted down their Fed Funds 2024 target projection by approximately 75 basis points (or three 25bp cuts) to 4.6 percent and shifted their 2025 estimates 30 basis points lower to 3.6 percent.
Source: BCIS/Federal Open Market Committee
If we combine this data, we can then see what the difference between market expectations are and FOMC projections:
Source: BCIS/Federal Open Market Committee
As the above graph shows, the market is ahead of the Fed in rate cut expectations. Currently, the market is calling for 75 basis points of cuts beyond what the members of the FOMC have projected. This began in earnest before the November FOMC meeting and accelerated approaching the December meeting as the following chart shows.
The natural question is: “Why are markets behaving contrary to Fed speak?”
There are two primary answers to this:
- Looking at data for almost 30 years, the median time for the Fed to go from a hike a cut has been 231 days. As the Fed last raised rates in July 2023, the March 2024 meeting tracks history pretty well and provides for some flexibility.
- The real Federal Funds rate and the neutral or natural rate.
Let’s look at the second as I believe the first is self-explanatory. The real rate can be gauged by taking the Fed Funds rate and subtracting a measure of inflation. The neutral or natural rate of interest (often referred to as r-star) is the real short-term interest rate expected to prevail when an economy is at full strength and inflation is stable. Where these can be used in conjunction with each other is taking the Fed Funds real rate and subtracting the neutral rate. This will show if the policy stance is restrictive or easy.
To illustrate this, we will look at the real Fed Funds rate using both the core Consumer Price Index year-over-year rate and the core Personal Expenditures year-over-year rate.
PCE calculated FederalSource: BCIS/Bloomberg Funds real rate:
CPI calculated Federal Funds real rate:
Both charts imply that real Federal Funds are above their average and due to their positive real rate, they can be considered restrictive (given the short nature of this rate). Restrictive, yes—but how restrictive is important. The charts below show both of these real rates minus the neutral rate – the difference is the amount the funds are restrictive relative to the neutral rate.
As the chart shows, after subtracting the neutral rate, Fed Funds is 61 basis points positive on a CPI basis and 101 basis points positive on a PCE basis; this tells us that both rates are restrictive. Furthermore, if it is established that the rates are restrictive vs the neutral rate, the next step is looking forward. While Core CPI (CPI less food and energy) is currently at 4 percent, one-year forward inflation expectations are currently 3.36 percent. If we accept that inflation is heading lower, then without a change to the Fed Funds rate, the real Fed Funds rate will be increasing. As this occurs, the spread to the neutral rate increases and makes the Fed policy rate even more (and overly) restrictive. Therefore, it might be necessary to trim the Fed Funds rate to remain simply restrictive.
If, however, things do not proceed down this path and the Fed stays higher for longer, the outcome will not be favorable. As the following charts show, the rally we have been witnessing has been premised on the Fed cutting the Fed Funds rate.
In every one of the above charts, you can see the change in the trajectory of the Fed Funds expectations helped fuel the current rally. This change in expectations breathed new life into the rally, which gathered steam as both institutional and retail investors offloaded cash and entered the market to jump on the bus. Should the Fed Funds expectations change, so will the course of asset valuations.
The Buzz Bottom Line: The market bus has left the station, but it is unclear who is driving, the market or the Fed. If the market is driving and the Fed is co-pilot, the Fed can use a different map and the wheels may come off of the market bus. With that I leave you singing the following:
I said, now you’ve got the Magic Market Bus (Too much, Market Bus)
I said, now you’ve got the hopeful Magic Market Bus (Too much, Market Bus)
Seems we drive higher every day (Way too much, Market Bus)
Better hope the pivot is less than a mile away (Way too much, Market Bus)
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