The Fed “Pivot”
The Fed “Pivot”
“Maybe central banks don’t actually stabilize an economy, which is their job. Perhaps
they are the instability.” – Peter St. Onge
Over the last 2 years, Federal Reserve Policy and speeches by Jerome Powell have all had one theme in common: “inflation is too high and the Federal Reserve will use all tools at their disposal to bring it down to 2%.” The topic of inflation and interest rates have been so pervasive that they are no longer topics reserved only for Wall Street and students of monetary policy, but now for the everyday man. Inflation has a way of doing that. When inflation is at or below the 2% target, people generally don’t notice it. When the costs of everyday items start significantly increasing, people notice! The fight to stop, or at least slow down inflation has become the primary objective of the Federal Reserve. On December 12th, 2023 the Consumer Price Index (CPI) numbers for November were released and showed some positive improvement with the annual CPI being 3.1%. This is a slight improvement from the 3.2% a month prior but still far from the stated objective of 2%. This CPI release date was important because 2 days later, Jerome Powell gave his scheduled FOMC speech in which he gave a forecast for Federal Reserve policy for 2024. In his speech, he said the Federal Reserve has most likely reached peak interest rate policy and that interest rate cuts were likely for 2024. He was cautious, and opaque with his words, which is normal… but Wall Street was elated to hear the news and the markets behaved well right after.
Despite not yet reaching a target increase of 2% inflation, and despite inflation in other parts of the economy still raging, Jerome Powell seems to have “pivoted” to a policy of no longer raising rates and to start considering the possibility of lowering rates. Wall Street is happy with the news and I’m sure many real estate professionals and investors are as well. To me however, it begs the bigger question, does Jerome Powell see something really bad in the economy that we don’t? Why would there be an abrupt change in Federal Reserve policy when the stated objective of normalizing inflation still hasn’t been achieved…?
Interest Rate Cuts
There has been speculation that the Federal Reserve is aware of something bad brewing in the economy. And to be fair, you don’t need to look far to find economic headwinds. We had several large banks fail in 2023, and the conditions that caused these banks to fail still have not been resolved. Big banks have a cozy relationship with the Federal Reserve and most would guess they have some say in Fed policy, at least behind closed doors. Many big banks continue to hold large losses on their books. Many of these losses are due to holding long-duration government bonds. I have written extensively about this in several letters in the past year. Banks are also having problems with the worsening commercial real estate crisis. Office buildings in many large urban areas of America have high vacancy rates. The post pandemic return to work hasn’t happened and many downtown areas of America are shells of their former selves. The last financial crisis was caused by a collapse in residential real estate, could commercial real estate be the cause of the next? A reduction in interest rates would be warmly welcomed by banks.
When it comes to guessing future interest rate policy, I find betting odds to be one of the best indicators out there. According to CME Fed Watch, the market is now pricing in a base case of 7 interest rate cuts in 2024. There's even a 10% chance of 8 rate cuts into 2024, with a ~1% chance of 9 rate cuts. In other words, markets are saying there is a possibility of up to 3 TIMES as many rate cuts as the Fed is guiding. Markets are expecting anywhere from 175 to 225 basis points of rate cuts next year. See for yourself…
We are currently at 5.25% to 5.50% Federal Funds Rate
There are many reasons why the Fed could be cutting rates significantly in 2024. My inclination to why we are suddenly seeing a pivot in Federal Reserve policy is the skyrocketing national debt. Washington DC is on a spending binge. Large budget deficits and high interest rates are making interest payments unsustainable. The Federal Government has just recorded a $1.7 Trillion deficit for fiscal year 2023. This is the 3rd highest ever following the $3.1 Trillion deficit in 2020 and the $2.7 Trillion deficit in 2021. These accumulating deficits have now brought the US National Debt to over $34 Trillion!
Chart provided by usdebtclock.org
To put this in context, this is only 3 months after we hit $33 trillion, 2 years after we hit $30 trillion, and 4 years after we hit $24 trillion. We are now entering exponential territory. These debt levels are not sustainable and will need to be reversed. There has been hope and optimism that technological breakthroughs in technology like artificial intelligence would boost productivity so high that this type of government spending could be sustainable, but I just don’t know that it is. The United States has $7.6 Trillion in debt that will need to be rolled over within the next year and if the Fed keeps interest rates above 5%, that debt will be extremely expensive to service. Therefore, it is my belief that the Treasury, White House and certain members of Congress may be the ones putting the most pressure on Jerome Powell to lower interest rates.
On paper, lower interest rates sound great. They have been largely responsible for boosting markets since the Great Financial Crisis. It has come to be known as the Zero Interest Rate Policy (ZIRP). Are we returning to this policy and if so, why would the Fed do that? Many investors and market analysts are unsurprisingly excited about a return to this type of policy, but this time, I have questions if it can actually be done. I am worried that underneath the surface, economic conditions have seriously deteriorated and the Fed may actually be panicking. I don’t want to speculate, but can’t rule that out as an option, especially considering the abrupt and drastic change in Fed Policy. It appears to me that the stock market may be the only thing left preventing the Federal Reserve from lowering interest rates. Any future weakness in the stock market, would most likely be the straw that breaks the camel’s back, so to speak, and force the Fed to cut rates. For that reason, I am cautious about the markets heading into 2024.
Even if the overall stock market is weaker in 2024, it doesn’t mean that there won’t be opportunity. One of my favorite Jim Cramer lines is, “there’s always a bull market somewhere,” and he’s right. 7 Large Cap Technology stocks were the bright spot for the economy in 2023 and I am doubtful, they will see returns this year that are anywhere close to what they had last year. In fact, negative returns for these big names are possible, especially considering how richly valued they are. While last year was the year of the large cap tech and AI stocks, I think 2024 Is going to be the year of the small cap stocks. By nature, there are far more small cap stocks than large cap, and therefore can be more difficult to cypher through and pick individual names. While there are many we like, indexing can be a powerful tool to gain exposure to this sector. The chart below compares the Nasdaq 100 to the Russell 2000, as you can see the Nasdaq, when priced in small cap stocks is at dot-com bubble highs, I see a possible rotation into small caps coming next.
In 2023, value stocks greatly struggled with rising interest rates. Despite that, we continue to buy and hold resilient stocks that we think will fare better if we are presented with a recession. These companies are profitable, have low to no debt, and also pay a dividend. Some consumers are getting squeezed by inflation and I think discretionary purchases could be lower in the coming year. Therefore, consumer staple stocks and low-cost service providers could outperform discretionary and durable goods.. Within the financial sector, we continue to like Berkshire Hathaway. They own many different high-quality businesses as well as a lot of cash and short-term treasuries. Cash has sort of been forgotten about as an asset class but it does offer a lot of value in this market environment. Money market funds are paying interest in the 4.5% to 5.4% range on an annual basis and can be a great place to keep “dry powder” while waiting for opportunities to invest. They also allow protection in the event of market uncertainty. Another asset class that we believe offers investor protection but with better potential return is precious metals. The base case for metals is that action by the Federal Reserve will bring about higher inflation and a weaker dollar.
Bitcoin - It has been a while since we have written about Bitcoin, but it has silently been performing very well over the last year and I think it will be a top performer both this year and next. It topped a little over $69,000 in November in 2021 before collapsing to around $15,000 in December of 2022. It currently sits around $44,000 and has a lot of momentum. I have a lot to say about the topic, but I think it may be better off saved for my next letter. In my experience, most people I talk to about it either don’t know much about it or have written it off as funny money. I have studied it deeply and believe it could potentially be the solution to our current debt problem and instability created by the Federal Reserve. I will dive into more at a later date but feel free to give me a call if you want to understand more.
2024 is shaping up to be an eventful year, we are potentially on the verge of major policy shifts from the Federal Reserve and we all seem to be feeling a collective anxiety about the markets, the economy, and our nation as a whole. We have a presidential election in November and if history is any indicator, markets generally tend to perform well in election years. There have even been accusations that the recent Fed Pivot is because it is an election year. Regardless, I will be watching accounts closely, looking for opportunity and doing my best to navigate what will certainly be a crazy year. In the meantime, I hope you had a Happy New Year and look forward to hearing from you.
Bruce Carlson, CFP®
Carlson Asset Management
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra IS or Kestra AS. The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. It is not guaranteed by Kestra IS or Kestra AS for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.
The article and any opinions expressed therein are those of Carlson Asset Management and do not necessarily represent the opinions or strategies of Dorsey,