All eyes on whether US Federal Reserve will make explicit promise to cut interest rates
THE mood swings of the world’s financial markets could continue if there is any ambiguity in US Federal Reserve chairman Jerome Powell’s statements this week at the end of the central bank’s two-day policy meeting.
The Fed is all but guaranteed to leave rates unchanged at current levels between 5.25 and 5.5 per cent on Wednesday (Mar 20), but it could still prove a historic meeting with a profound impact on markets if the central bank definitively tips its hand on its next move.
The outcome that the stock market bulls are counting on is an explicit – if likely tacit – promise to cut interest rates in June. Most Wall Street brokerages anticipate that will be the date for the first of what is likely to be three quarter-point rate cuts in 2024.
That is the scenario the stock market was getting excited about during its February surge. Fed officials, including Powell himself, had earlier acknowledged a clear turnaround in inflation.
An unexpected rebound in price rises at both the consumer and wholesale inflation levels in February has now cast some doubt over that eventuality, causing a correction in recent weeks.
One swallow does not make a summer, of course, but the trend of softening inflation itself is relatively new. Petrol and food prices in the US are rising fast or remaining stubbornly high, depending on which gauge you look at.
Any sense that the Fed is getting nervous about a second wave of inflation would strike fear in the stock market. In a statement that followed last week’s consumer price data, Powell seemed to suggest that it did not affect the Fed’s resolve to cut rates at some stage this year.
Still, in deference to the heated inflation data, the rate-setting committee could stick to the deliberately vague statements on the timing of rate cuts. In a market that is already richly priced, such vagueness alone could be enough to cause a major sell-off.
Since the last time the Fed’s official “dot plot” projections of rate levels appeared in December, futures markets have gone from pricing in a near certainty of a June cut to giving it roughly a 50-50 chance.
The broad S&P 500 has risen about 20 per cent since the fourth quarter, largely because traders picked up the scent of a rate cut coming in the first half of the year rather than the second half.
“It wasn’t that long ago some thought they would start at the March meeting, but it’s been delayed,” said JD Joyce, the president of Houston-based financial advisory Joyce Wealth Management.
“It looks as if the Fed has done the unthinkable. It looks like we will have a soft landing or no landing, even though some of the rhetoric on Wall Street was a possible economic tsunami. It seems like they are retracting those predictions.”
Beyond economic growth
The speculation about rate-cut timing goes beyond the economic-growth implications, however. Interest rates are the most important factor by far in the sustainability of the current rally.
The valuations of some artificial intelligence giants, including chipmaker Nvidia, are getting into heady territory, around 100 times earnings.
The overall valuation of the S&P 500 is also rising, albeit more gradually. A price-to-earnings ratio rising from 15 times earnings a year ago to 20 times earnings at the current level makes perfect sense in a world where credit is getting cheaper for corporations.
If the Fed does not cut rates in the near future, most strategists would view the S&P 500 as overpriced at the current level.
The property market is also in the front line of interest rates. The housing market in the US effectively ground to a halt during the last year, ever since the 30-year mortgage rate topped 7 per cent.
That is a figure most Americans of homebuying age have never seen before. Currently, rates are in the “high sixes” and are likely to fall further if Powell strikes a dovish tone on Wednesday.
“If you are sitting on 3.5 per cent that you refinanced during the pandemic, it’s going to take a lot for you to move off that to upgrade, to want a better neighbourhood or a house closer to the lake”, or whatever the dream may be, said Eric Marshall, president of mutual-fund firm Hodges Capital.
The nightmare scenario for the stock market is if the Fed’s dot plot reduces the anticipated number of cuts the central bank anticipates in 2024.
“We expect the Fed to revise its outlook in favour of stronger growth and somewhat firmer inflation, while leaving unemployment near multi-decade lows,” said economists at Bank of America Global Research.
“If so, it can guide markets to a cutting cycle that begins in June, but the clear risk is it defers cuts. The median 2024 dot should still show three cuts, but it is a close call.”
