The anticipation of interest rate cuts by the Federal Reserve next year is generating excitement in the markets, but Wall Street analysts caution that this could be a mixed blessing, signaling potential concerns about the broader economy's health.
Expectations are high among investors for the Fed to lower interest rates in 2024, especially as inflation shows signs of easing and the Federal Reserve refrains from further hikes in its benchmark rate. The CME FedWatch tool indicates a 95% probability that rates will be reduced from their current levels by the end of next year. This optimism was further bolstered by a recent inflation report showing a 3.2% rise in prices in October, slightly below the forecasted 3.3%.
However, the possibility of rate cuts presents a complex scenario for investors, as such measures typically reflect a response to economic deceleration. While rate reductions aren't inherently bullish, the end-of-year economic slowdown is becoming increasingly apparent.
Former PIMCO chief economist Paul McCulley expressed his views on CNBC, highlighting the significance of the current economic data and its potential influence on the Fed's decision-making. He suggested that the Fed might soon consider their policy sufficiently restrictive, indicating an end to tightening measures and possibly setting the stage for future easing.
Yet, the potential for rate cuts as a bullish market catalyst is not straightforward. The need for Fed policy relaxation often arises in response to a slowing economy, with deeper cuts likely in the face of a full-blown recession.
Market participants have been optimistic about a Fed rate cut spurring a stock market rally. Nevertheless, the prospect of a recession poses a significant challenge to equities, with potential declines of up to 20%, as estimated by JPMorgan's chief market strategist.
Chris Grisanti, chief stock strategist at Mai Capital Management, in a recent interview, likened the current economic trajectory to a puck gliding towards a slow economy. He noted that rate peaks typically signal troubling times ahead for equity investors, reflecting an economic slowdown that could manifest within three to six months.
Historical analysis from Deutsche Bank strategists reveals that in five of the last ten recessions, the Fed reduced interest rates prior to the downturn, suggesting that rate cuts don't automatically avert a recession and often indicate looming problems.
UBS strategists predict a more drastic rate cut of around 275 basis points as the economy enters a recession in the middle of next year, significantly higher than market expectations. This would involve reversing much of the monetary policy tightening enacted since March 2022 in response to the forecasted recession in the second and third quarters of 2024, along with a continued slowdown in both headline and core inflation.
Economic indicators already point to a slowdown. The Atlanta Fed's forecast for real GDP growth this quarter is around 2.2%, a sharp decline from the 4.9% growth of the previous quarter. Retail spending, according to the U.S. Census Bureau, decreased by 0.1% last month, marking the first decline since March and suggesting that consumer spending, a key driver of this year's economic resilience, might be waning.
The cooling labor market adds to these concerns, with the economy adding 150,000 jobs in October, a notable decrease from September, and the unemployment rate increasing to 3.9%. These job figures are nearing the activation threshold of the Sahm rule, a reliable recession indicator. Claudia Sahm, the creator of the Sahm rule and former Fed economist, indicated to CNBC that while a recession isn't current, the proximity to this critical indicator threshold doesn't guarantee the economy's continued resilience.
