Episode 12 – Federal Reserve Rates in 2024

[MUSIC PLAYING]

Hello, everybody. Thank you for tuning into Market Perspectives, a Mercer advisor podcast where we provide a data-driven, common-sense perspective on the economy, on markets, and on investing. I’m your host, Don Calcagni, Chief Investment Officer at Mercer Advisors.

Today’s topic is going to focus on, what we’re calling at the moment, the coming fed pivot of 2024. The US Federal Reserve had a meeting the other day. It was the meeting of the FOMC. That’s the Federal Open Market Committee that sets interest rates. And coming out of that meeting were a couple of important items.

First and foremost, we should first acknowledge that interest rates did not change. The Fed decided to keep interest rates where they are currently. They did not raise them. They did not cut them. But importantly, coming out of that meeting, there has been a communication from Fed Chairman Powell that there has been a discussion about when perhaps to begin easing monetary policy, that is Fed speak for ultimately cutting interest rates.

And interestingly, when we actually look at the notes coming out of that meeting, the Federal Reserve themselves are actually forecasting that they will cut interest rates three times, three times in 2024. So this is a significant pivot from where we’ve been certainly over the past two years.

It is certainly a pivot just from where we were several weeks ago when fed Chairman Powell had suggested in a media interview that it was still premature, it was too early, perhaps, to discuss seriously cutting interest rates. So this is a very significant change. It’s not one that’s entirely unsurprising when we look at some of the economic data, which I’ll get into here in a few moments.

But before I do that, I wanted to just back up and give our listeners a quick history lesson and explore, how did we get here? How did we get to a place where we went from virtually 0% interest rates a few short years ago to now having interest rates somewhere around 5.25% to 5.5%, that is the Fed’s target interest rate range.

Well, if just rewind the tape, I don’t think any of us need reminding that we had a global pandemic. We had COVID that really gripped the economy beginning in February and March of 2020 that essentially disrupted global supply chains in a very, very significant way.

And in order to combat the economic effects of COVID, the Federal Reserve, led by Chairman Jerome Powell, basically took interest rates to 0. They began buying bonds in financial markets. To say that differently, they began printing money and injecting digital dollars essentially into the global economy.

Fast forward to April of 2021, the economy had stabilized. Doesn’t mean that the supply chain stabilized, but the economy began to grow again. And in April of 2021, what we observed is that inflation began to pick up quite significantly, and we began seeing some of the highest inflation that we had seen in years.

And so much so that by March of 2022, so this is 11 months after we started to see inflation really heat up, is when the Fed finally began to raise interest rates.

So we had inflation building throughout the economy. We still had global supply chain disruptions. China was essentially shut down.

China is essentially the world’s factory. Chairman Xi of the Chinese Communist Party had a 0 COVID policy and took a very rigid approach to combating COVID in the People’s Republic of China. And so supply chains remained severely disrupted.

But again, it wasn’t until March of 2022 that the Fed admitted that the inflation we were beginning to see looked like it was going to be persistent. It wasn’t going to be transitory. That was the term they were using for a while. They admitted that it looks like it was going to be more permanent. And so the Fed got serious, began raising interest rates in March of 2022, and began raising interest rates quite significantly beginning in May and June of 2022.

Since then, the Fed has raised interest rates, like I said, to our target range of 5.25% to 5.5%. That’s where we are today. Now, what about inflation? Inflation peaked at over 9% in June of 2022. So about 18 months ago is when inflation peaked.

Since then, given that we have higher interest rates, and given that we have seen supply chains successfully stabilize and begin to normalize, we’ve seen inflation come down quite dramatically since then. Now, I think it’s important to explain, what do we mean by inflation coming down. We don’t mean that prices have come down.

So you may be thinking to yourself, wait a minute, Don. When I go to the grocery store, prices are still high. Nothing has come down. You’re absolutely right.

Inflation coming down is what we call disinflation. That’s not deflation. Deflation is when prices decline. Disinflation is when the rate of growth in prices begins to decline.

So we went from over 9% inflation in June of 2022 to just this week, 3.1%

inflation. So let me be clear. Prices are still creeping up. The Fed, the economists, we want there to be a little bit of inflation. Deflation is a really bad thing. So a little bit of inflation not a bad thing.

2% is the Fed’s official target. They target an average of 2%. But at the moment inflation has come down quite dramatically to about 3.1%. So that’s how we got to where we are today.

Now, there’s a bit of a tug of war in the economic data around whether or not we think inflation is going to persist going forward, whether or not we think the economy is going to slip into recession. And this is why we have economists. This is why we have the Bureau of Labor Statistics. This is why we have the National Bureau of Economic Research, is to do all this research to help us get a sense of what is the direction of the economy.

And when we look at the data, by any objective measure, the economy is doing exceptionally well. Coming into 2023, economists polled by Bloomberg had put the odds of recession at 80% That is staggering. Yet Q3 economic growth for the US economy came in at a piping hot 5.3%. That is some of the highest economic growth that we have experienced in years.

So the economy continues to do well. Unemployment remains near historic 50-year lows. Now, to be fair, job growth has softened a little bit, but we still have very, very low unemployment. Like I said, the economy continues to grow and inflation has been coming down. This is almost a Goldilocks type scenario. And for the Federal Reserve, it certainly is.

Their biggest concern over the past 18 months to 24 months, as they began raising interest rates, has been ultimately pushing the economy into recession. And they’ve even made comments that they weren’t afraid to push the US economy into recession, if that’s what was necessary to bring down inflation.

So this is what we call the proverbial, quote, “soft landing.” So if you’re a reader of the Wall Street Journal or any other economic news provider, you may see that term from time to time. This is a soft landing, meaning that the Fed has successfully raised interest rates. They effectively unwound 15 years of quantitative easing in approximately 18 months. That is nothing short of miraculous.

But they raised interest rates. They have brought down inflation. I think there’s still some work left to be done.

But they have done that successfully without tipping the economy into recession. They have certainly had help from stabilizing supply chains. They have certainly had help from the US consumer, which remains the primary engine of US economic growth.

Consumers coming out of COVID had built up what we call excess savings, and they have certainly been digging into those savings to continue to sustain consumer spending. And that has certainly helped the economy over the past several quarters. So that’s where we’re at today.

But again, there is this tug of war. We have some good data, but then we also have some concerns. We have concerns that look, consumer spending might soften after they burn through that excess savings that they built up during COVID. That is a concern. And there are some economists who still think that there is a probability, a relatively high probability that the US economy might tip into recession.

They cite things like perhaps geopolitical risk, the tensions between the United States and China with respect to Taiwan, geopolitical tensions in the Middle East, given the war in Gaza and given the war in Ukraine. So there are certainly very significant geopolitical risks that could certainly present a risk, a challenge to GDP growth going forward.

We’re also heading into a presidential election year. And without diving too deeply into US politics, we’re in a challenging place at the moment politically. So that’s going to present some challenges, I’m sure, for the economy as we get towards the end of next year. So it’ll be interesting to see how consumers respond to what’s happening in US politics.

There is this tug of war with respect to the data. But I think by large, when we look at the data as a whole, we’re in a pretty good place economically. So I think, directionally, the Fed is accurate. I think directionally they are right to begin to suggest that, look, maybe in 2024, we could begin bringing interest rates back down. The Fed’s biggest concern at this point is that they have a target interest rate of about 5.5% and inflation of about 3%.

That means that they have a real interest rate, real meaning inflation-adjusted, a real interest rate of about 2%. That’s pretty high. And if the economists are right, if the Fed is right, that could choke off economic growth going forward. The Fed knows this. And the Fed I have no doubt, is concerned that real interest rates could choke economic growth in 2024.

Now, how did markets respond?

Well, yesterday the Dow Jones hit an all-time high.

That’s pretty significant, especially coming on the heels of some pretty ugly returns in 2022. So the Dow hit an all-time high. And asset prices–

and by asset prices, I mean everything from stocks to bonds to real estate rallied.

And we actually had one of the best what we call cross-asset rallies in markets in the past 15 years just yesterday. So when we look across the market broadly, what we observe is that we had one of the best rallies in financial markets yesterday than what we’ve seen in probably about 15 years. So very significant.

So does this rally have staying power? Do we really think the Fed will ease rates in 2024? Markets think so. Clearly, if we look at what happened with asset prices yesterday, markets clearly believe that this rally has legs. The market believes that the Fed will certainly deliver on its communication, that it will likely cut interest rates in 2024.

Now, I would just caution for a moment here. Markets tend to overreact a bit. Investors tend to get caught up in the emotions of the moment, whether that be getting overly giddy about dotcom stocks, real estate prices in the mid aughts. Today, artificial intelligence stocks. We’ve all seen this one many, many times before.

And so I do think that could be the case here, that markets are perhaps getting a little overly excited. I think directionally, however, the market is right. Directionally, the Fed is probably right. The Fed is probably going to bring rates down, some in 2024, probably not as much as the market would like. Probably not as much as the market is forecasting at the moment, but I think directionally the market and the Fed are both right that rates will ultimately be coming down.

Now, what are the investment implications of this news? Well, let’s first talk about cash. Many investors we’ve observed have been sitting on significant cash over the past year or two. And look, that’s totally understandable. Totally to be expected. When you have money market funds yielding 5%, 5.5%, I think for those of us who have lived through this low interest rate environment, that is a breath of fresh air.

I admit it, it’s a little hard to take that cash that’s earning 5% and deploy it when you’re earning such an attractive yield on your money market funds. Now that said, that said, let’s remember that your money market funds are what we call extremely short duration investments. What do I mean by that?

What I mean by that is money market funds are investing in short-term paper. These are overnight repo agreements and things like that. What that means is the duration in your money market fund is typically less than 30 days. And sometimes it’s a lot shorter than that. Sometimes it’s 10 to 15 days.

You have significant reinvestment risk. As rates come down, you will see that the yield on those money market funds will come down very quickly with any future prospective interest rate cuts. So keep that in mind. If you’re looking to lock in today’s higher interest rates, you need to invest in longer maturity bonds.

So if you liked today’s 5% that we’re earning on treasuries, you should invest that in treasuries. Put it into a Treasury bond ladder. We manage many hundreds of millions of dollars in those strategies here at Mercer. I would encourage you to reach out to your advisor to ask about that. That could be a very suitable solution for that longer term cash.

We also have a series of bond strategies that will invest in bond maturities, going out as far as five to sometimes even seven years. So again, I would encourage you to talk to your advisor. So in a declining rate environment, you want to be adding some duration to your fixed income portfolio.

The opposite is true. When rates are rising, you want to stay short duration, but we don’t think that that’s where we’re at. And in fact, our investment committee that he voted in July to begin adding duration back to our fixed income portfolios.

We shortened duration dramatically in January and April of 2022, before the majority of the Fed’s interest rate hikes.

And then we added back duration in July after it was clear that the Fed was likely done raising interest rates going forward.

I would encourage you to do the same. Discuss that with your advisor.

Now, don’t misunderstand. If you’re sitting on cash that you need for short-term liquidity purposes, absolutely. I encourage you that should stay in a money market fund. So please don’t misunderstand. This is why it’s absolutely imperative that you meet with your advisor to discuss what is right for you and your family.

What about stocks? Well, equity valuations will certainly be buoyed by declining rates. When rates go down, that is a tailwind for stock valuations, for equity valuations. Right now, the S&P trades at about 19 times earnings.

It’s a little frothy. You still want to make sure that your portfolio has a tilt towards less expensive stocks, high quality, less expensive stocks. It’s those M7 AI technology stocks that are really pushing up market valuations. So you still want to be judicious. But again, the point is that declining interest rates are a good thing for equities.

What about non-US stocks? Non-US stocks are even more attractive on a valuation adjusted basis. And this is an important point. Lower interest rates will also push down the US dollar.

We started to see some of that yesterday. A declining dollar, a weaker dollar is actually a good thing for US investors who own non-US assets. That is a tailwind for that part of your portfolio. So that is generally a good thing.

So in closing, I encourage all of our listeners to work closely with their advisors. These are challenging times. Market economic data can be confusing. It can be very contradictory. And an advisor can help you sift through that noise.

They can help you carefully evaluate your family’s need, your family’s tolerance, your family’s capacity for investment risk. They can help you map out a personal investment policy that makes the most sense for you, and one that has the best odds of achieving your long-term goals. So I would certainly encourage all of us to work closely with our advisors.

Explore your cash needs. Explore your liquidity needs. Make sure your asset allocation makes the most sense for you and your family, given your goals, your objectives, your need, capacity, and tolerance for investment risk.

Well, that’s all for today. Thank you for listening. Should you have any questions, please, as always, feel free to reach out to your advisor here at Mercer Advisors. I’m Don Calcagni, and from all of us here at Mercer Advisors, we wish you and your family a safe and a happy and a healthy holiday season. Thank you.