The market forgets about higher for longer and anticipates up to five rate cuts in 2024

The mantra of higher rates for longer that the U.S. Federal Reserve (Fed) and the European Central Bank (ECB) have insisted on repeating in their statements over the last year seems to have been short-lived for the market. It took a lot of work and explaining for both Fed Chairman Jerome Powell and ECB President Christine Lagarde to make the market see that rates would remain high for as long as necessary, until inflation converged clearly and unidirectionally on the 2% target.

Back from the summer holidays, when it seemed that investors were really starting to buy into the central banks’ discourse, a couple of lower-than-expected inflation figures were enough to make even monetary policymakers doubt their own rhetoric.

In the month of November alone, the 10-year US Treasury yield fell by 60 basis points (from 4.93% to 4.33%) and the trend continued at the start of December. If we look at the European markets, the German 10-year benchmark was trading at the end of November at an IRR of 2.45% and the Spanish benchmark at 3.47% when only one month earlier they were trading at 2.81% and 3.88%, respectively.

With this sharp decline in interest rates, it's not surprising that November was the best month for government bonds since 2008. We also had a very good month for equities, confident that the economy is steadily headed for a soft landing, where the disinflation process will stay on track without causing any damage to growth.

This is the only way to make sense of the outlooks for corporate earnings growth for 2024 that are already circulating, with analysts predicting double-digit growth for the year as a whole. The market is still in pendulum mode, which requires a more detailed analysis of the main factors affecting market performance so as to avoid getting carried away by euphoria.

The macroeconomy is not so fast

The strong revaluation of assets seen in the last month has been mainly driven by an adjustment in the terminal rate forecast. In just a few weeks, the market has experienced as many as four 25 basis point cuts in the case of the Fed and five from the ECB.

The justifications for these cuts may come partly from transitory issues (energy prices have fallen sharply) and base effects, given the comparative November readings this year, which were compared to inflation rates just a year ago that were close to double digits.

The matter at hand is thus whether these reasons alone are sufficient to justify so many rate cuts or whether there's some other reason for them. Looking at the macroeconomic data, it’s recently been better than expected based on the evolution of the macro surprise index. As a result, growth expectations for the year 2024 in the United States have recently been revised upwards (to 1.2%), although in the Eurozone they have been revised downwards, but still far from any potential recession (1.3% for Spain, 0.3% for Germany and 0.6% for the Eurozone as a whole).

With respect to inflation, the latest known readings have not greatly affected forecasts for the coming year, which remain at manageable levels for central banks, but still far from the 2% target (2.7% in the United States, 2.5% in the Eurozone and 2.9% in Spain).

Thus, from a purely macroeconomic point of view, such a sharp change in expected interest rates would not be justified. What then could have led central banks to say that rate cuts were possible?

Real rates

Real rates are found by discounting inflation from nominal interest rates, and they’re typically a significant indicator of whether monetary policy is being restrictive (higher real rates) or expansive (lower real rates). Major discrepancies can thus often be found in the way they’re calculated.

Normally, the difference between the nominal rate and the latest inflation data is used. But from a financial point of view, it would make more sense to calculate them as the difference between the IRR of the nominal 10-year bond and the inflation expectation during the same term (using 5-year futures within 5 years of inflation).

With inflation falling as it has in recent months and nominal interest rates remaining high ('higher for longer'), real rates have risen. So monetary policy has become quite tight in the case of the United States and neutral in the Eurozone (albeit after more than a decade of negative real rates).

High rates with high inflation have no effect, but higher rates with lower inflation have begun to have an effect on growth in the Eurozone and may begin to have the same effect in the United States. For this technical reason alone, and because long-term inflation expectations remain stable, rate cuts may be justified, although not as many as the market has priced in.

The liquidity paradox

Central banks' decisions in setting the price of money usually become the center of attention. But as we’ve been saying month after month in these market updates, what really matters for the market is still liquidity, as it's the money that’s created or destroyed in the system and that serves as the “oil” for the engine of the economy to run at full capacity.

While we've begun to anticipate from recent statements that central banks may begin to cut interest rates, there appears to be no imminent change in the withdrawal of liquidity from the market through the sale or redemption of bonds that central banks had accumulated on their balance sheets after years of expansionary monetary policy ('quantitative easing').

Liquidity is usually tight at the end of the year, but this is due to the avalanche of bill issues by the U.S. Treasury. The relentless fiscal spending that Joe Biden's administration undertook after the debt ceiling extension was agreed upon means that we've likely seen a very positive November from a liquidity standpoint. However, we expect this unexpected rally to fade in the coming months and the withdrawal of liquidity to continue.

Although it’s likely to happen more gradually, as it wouldn’t make sense for central banks to start lowering interest rates while continuing to reduce their bond portfolios.

Conclusions

The sharp swings we've seen in the last month and a half wouldn’t be justified, given that the macroeconomy is slowly adjusting and the market is reacting more like a pendulum. Nevertheless, it's true that the prospect of rate cuts has some merit from a technical point of view (real rates) but not from a fundamental point of view, given that inflation is still above target, growth is resilient and the labor market remains strong. Perhaps only in the Eurozone could there be greater justification, because although real rates have barely moved into positive territory, they’ve already begun to clearly weigh on growth.

In market terms, investors are therefore discounting the scenario that we described as “idyllic” in our Asset Allocation Committee, which means generalized and excessive optimism for now, given that some risks prevail.

For example, the sharp easing of financial conditions over the past month and a half could be a tool that central banks use at their December meetings to let the market know that the battle against inflation has not yet been won.

Moreover, geopolitical conflicts are still ongoing, and the course that they will take (along with raw materials) is impossible to forecast, especially in a year like 2024 when more than half of the world's population will be called to the polls. We’re therefore cautious about the consensus that's predicting a great year 2024, although everything is pointing to a positive start to the year.