May 2, 2024
The Fed decided yesterday to hold its ground on US interest rates, noting lack of progress on inflation and thus choosing - one more time - not to cut. So US rates remain steady at the level between 5.25%-5.50% (maintained since July 2023), the highest level in more than two decades.
Remember that the latest US inflation report (coming above expectations, at 3.5% yearly inflation) has been a negative surprise to the Central bank - and markets.
As an outsider to financial markets I would ask: are we in trouble if the Fed did not cut rates, or is it actually a good thing?
Well, it depends.
On one side, the global economy is doing fine. First, US growth continues to be resilient despite a weaker-than-expected GDP print for the 1Q24 (at 1.6% year-on-year, down from 3.4% in December). Second, European growth is recovering and it is finally back into expansion as suggested by recent PMIs.
Also the IMF says that we would need a lot of bad news to derail the economy into recession. In other words, a recession is very unlikely to happen at this point. Yes, someone is voicing stagflation concerns but we need more proof. I dismiss the noise for now.
Paul Krugman, nobel in economics, has even said recently that the economy is doing as well as in the late 1990s (the link requires a subscription to NY Times, but you can find my video summary here).
Overall, it seems that the economy is not a concern. So we do not need to see cuts to save the economy - for now.
But market expectations have been fluctuating wildly - and so have some asset prices. For example, stocks have been on a roller coaster lately - especially the Nasdaq. See Tesla down here (blue line).
Also longer-dated bonds continue to underperform. See below another jump for US 10-year yields on the back of the Fed announcement yesterday.
That is bad.
Earlier in 2024 investors were betting on 3x cuts in the US. More recently, expectations moved to just 1x cut to take place before year-end, thus causing growth stocks to be so volatile and bonds to further underperform.
But hold on.
Equity markets rallied yesterday. How moody. And why? Because the Fed is not cutting now but...it could still be cutting later. And they are slowing down QT, trying to avoid liquidity shocks in bond markets.
So where should investors place their bets?
We have learnt in the past two years that equity markets like some nominal growth via inflation. With positive and growing earnings, there is no reason to panic in stocks (if not for fairly expensive valuations).
Bonds have performed poorly, as they always do in a context of rising/high rates. Duration bets did not work so far, and they will not work for longer. Do we need to abandon ship in fixed income then?
Not so fast. Rarely we had such an opportunity to pile-up such elevated income from ultra-short bonds. US 3-month Treasuries will pay you close to 5.5% in USD (see below) and German 3-month Bunds will pay you close to 4%.
That's almost free money.
Enjoy it while it lasts.
