• This week’s widely anticipated Federal Reserve meeting brought signs of relief on interest rates.
• While the Fed, like the Bank of Canada last week held steady on rates, the Fed signaled likely rate cuts in 2024.
• How long do markets typically have to wait for central banks to reverse course?
• Markets have already priced in lower interest rates as they “front run” the Fed, but confirmation from the Fed itself sparked a sharp relief rally across asset classes.
• The evolution of inflation will be key to how quickly central banks can pivot from on-hold to rate cuts, and as always, we need to expect the unexpected and be prepared to stick to a well thought out plan.

Fed keeps market party going

The last few weeks have seen holiday party season in full swing, and coincidentally or not, markets have been throwing a bit of a party of their own, with both bonds and stocks continuing the healthy rally that started on Halloween. It seems like the Federal Reserve felt left out and wanted to get in on the party as well. This week when they announced another policy decision with no change to interest rates, but the details behind the decision seemed to suggest they are getting ready to refill the punch bowl they so swiftly took away during the first half of the year.

Markets moved well ahead of central banks in expecting rate cut

Markets have been pricing in rate cuts for a while now, and the Fed followed suit, upping their median forecast to three rate cuts from two in 2024, news that markets took to with great enthusiasm. Meanwhile, in the press conference that followed, Fed Chair Jay Powell did little to push back on the market’s view that rate cuts will be coming sooner rather than later. As it stands today, markets are pricing both the Federal Reserve and Bank of Canada to end 2024 with policy rates of about 3.8%, a sharp drop from today’s levels. This is already being reflected in bond yields, with 2-year government bond yields falling around 1% since October.

How long do we have to wait for lower interest rates?

Now that the market is firmly focused on interest rate cuts, the logical question is “when?” Below is the historical gap between the last rate hike and the first interest rate cut from the Federal Reserve. Looking at the data it is pretty clear that before the late 1980s, the gap between the last hike and first cut was incredibly short at 1-3 months, and for the full data set the average is 5.5 months. Pre-1990s era was one where central banks raised interest rates until something “broke” and were quick to turnaround and cut. It was also an era of high and unpredictable inflation, making the practice of monetary policy (and asset management!) much more difficult.

Starting in the late 1980s under the stewardship of Alan Greenspan, the gaps between last hike and first cut grew longer. Inflation was more subdued and predictable, Fed officials gave interest rates time to work their way through the system, and then cut rates when the economy weakened. Since the late 1980s, the gap between last hike and first cut grew to an average of 9.5 months. While it may feel like only yesterday that we were talking about the next rate hike, it has actually been about 4.5 months since the Fed last raised interest rates, suggesting we could see rate reductions commence within the next six months.

Stocks have historically done well once rate hikes cease

As we discussed last week, there is good reason for markets to be keenly focused on the end of rate hikes. First among them is the data below that shows stocks in both Canada and the U.S. historically put up strong returns and a higher than normal probability of a positive return in the 12 months after the Fed stops raising interest rates.

The path forward for interest rates will rest on inflation and “events”

Despite all the enthusiasm emanating from markets this week, the Federal Reserve did make it clear that the next move on interest rates will rest on inflation, and that they would still raise rates if needed. As seen below, the Fed’s preferred inflation measure has been coming down sharply and they expect it to hit 2.4% by the end of next year. One would assume that is close enough to the 2% target whereby more rate hikes are likely off the table and the threshold to cut drops quite sharply.

“Events, dear boy, events.” is a quote attributed to 1960s British Prime Minister Harold Macmillan when asked what could blow his government’s agenda off course. The same can be said of markets! All of the above assumes the world unfolds according to the Fed’s expectations. As we have seen in the past, events can get in the way. Nearly every year “something” happens that can upend policymakers’ (and investors) best laid plans, be it a pandemic, war or perhaps a regional banking crisis. Volatility will continue to be an enduring theme for investors whether we like it or not, but as always the key is how we react to it. The correction over the autumn showed how extremely challenging market timing can be, and once again the market turnaround has been so swift that anyone who found themselves overweight cash has had a difficult time getting reinvested. Maybe 2024 will be a “boring” year where markets deliver a drama-free high single digit return – wouldn’t that be nice! – but we wouldn’t bet on it.

The Harbour Group

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