Brainwashed by the Fed

If you repeat a lie enough times, eventually people begin to believe it.  That is what the Fed has done with both its higher for longer mantra, and now brainwashing the financial community into believing its dot plot of 3 rate cuts for 2024.  Since when has the Fed been an accurate predictor of future rate moves?  Its counterintuitive, but the STIRs market has been more accurate in predicting future rates than the group that actually makes the interest rate decisions. 

Stocks and bonds are all just one market now.  The correlation can hardly get more positive between the two.  The consensus view is that the STIRs market is pricing in too many rate cuts (150 bps) for 2024.  Its been the recent weakness in the bond market that's infected the stock market, leading to horrible breadth.  Russell 2000 has lagged badly since the start of the year, just as the crowd was warming up to small caps, and expecting them to outperform in 2024.  You are also seeing the VIX make higher highs even though the SPX is hardly going down.  It all looks like a possible perfect storm, but I just don't see it happening.  People are too pessimistic about the rate cut path. 

Investors are worried that the Fed will disappoint the market expectations of 150 bps of cuts this year.  I'm in the minority view that 150 bps is the minimum amount that the Fed will do if there is a no landing scenario (very unlikely given weak global growth in Asia and Europe, lower fiscal impulse in the US).  In a soft or hard landing scenario, the Fed is likely to cut in 50 bps increments, not 25 bps as most expect.  It will only take 3 meetings to get 150 bps of cuts in that case.  That can be done over a period of 3 months.  In past economic slowdowns, the Fed has almost always made chunky rate cuts of at least 50 bps increments.  There is nothing to make me believe that they'll stick with 25 bps moves when unemployment is rising and inflation is falling.  

Fed Funds rate probability for Dec 18 2024 FOMC

Just as rates rising didn't have much of a restrictive effect on the US economy, rates falling won't have much of a stimulative effect.  So I can definitely see a situation where the medicine of a few rate cuts is too weak, forcing the Fed to give the patient even stronger medicine in the form of 50 or 75 bps cuts at a time.  

You see some leading indicators which seem to have bottomed, but much of it is coming from the steepening of the yield curve and reduction in credit spreads, basically financial conditions.  Financial conditions are overrated as an economic leading indicator when there is so much fixed debt outstanding that is unaffected by interest rate/yield moves.  Too many are jumping the gun and trying to front run the turn in the cycle.  There just is not that much pentup demand in manufacturing (inventories not low enough), as we never got the recession cleanse that was needed to restart a strong up cycle.  The excess savings of the bottom 50% is gone (wages not keeping up with inflation), and many have to pay back student loans, which just restarted a few months ago.  

The job market is slowly loosening, with fewer temp work (leads permanent work in the cycle), meaning higher unemployment and fewer wage increases for 2024.  The key is profit margins of small businesses, which are likely getting squeezed as the Rona stimmies are now gone but the higher rates on loans remain.  With lower profit margins at small businesses, they either have to cut workers or reduce working hours.  Both will slowly feed into less wages and lower consumption.  Just looking at how weak the Russell 2000 has been so far this year, as well as for most of 2023 (vs SPX).  That gives you an idea of how smaller companies are doing in this higher rate, higher labor cost environment.  

You likely won't be seeing a recession, just because of the huge government deficits driving nominal GDP growth, but the weakness of small businesses and reticence to make big investments ahead of the maturity wall coming up in 2025 will lead to a noticeable growth slowdown, IMO.  Its being ignored for now because rates came down so hard in November and December, and the stock market went up so much.  Probably the best sector to be invested for the year will be in defensive sectors like consumer staples and utilities, as you are going to get a slower economy leading to chunky rate cuts by the summer, and people are not positioned for that.  The Fed has even stated that even without labor weakness, they will make rate cuts as long as inflation is falling. 

With the recent rise in yields, bonds are getting interesting here for a swing trade, as I don't see yields able to keep rising ahead of a rate cutting cycle which is being underestimated by the majority.  The bond market is sending a strong signal when the yield curve keeps steepening despite the widespread belief among the financial media that too many rate cuts are priced in.  

Because I don't think yields will keep going higher, I am a reluctant short here in SPX.  This trade was mainly a play on the seasonally weak January opex week as well as the somewhat overbought nature of the market last Friday.  I will be looking to close out my short by Friday, as some of the January opex weakness has been brought forward this week.  Also, don't want to hold a short position going into tech earnings season starting next week.  Once we consolidate this month, I am expecting a strong February for stocks and bonds as weaker economic data starts to come in, moving investors more towards my view of a more aggressive rate cutting cycle than is being priced in.