Markets sink as Fed makes hawkish pivot

Fed Spooks the market as we wait for BOE

The Federal Reserve may have cut rates on Wednesday, but the market thinks it could be a while before they cut again. The expectation was for a cut and then a pragmatic pause in the Fed’s rate cutting cycle, however, what the Fed delivered was a hawkish cut, which raises the possibility that the next move by the Fed may not be a rate cut.

Fed upgrades growth outlook, and revises inflation higher

The Fed’s economic projections saw a huge uplift to both growth and inflation outlooks. The Fed upgraded the GDP forecast for 2024 to 2.5% from 2% in September, and for 2025 to 2.1% from 2%. The core PCE forecasts for 2024 were raised to 2.8% from 2.6%, and for 2025 to 2.5% from 2.2% in September. Expectations for US inflation is that it will move farther away from the Fed’s target rate in the coming year, which could lead to tighter monetary policy in the short term. The Fed has a dual mandate, but they don’t need to worry about rising unemployment. The recent strength in the US labour market led the Fed to revise down their projections for the unemployment rate. The unemployment rate for 2024 is expected to be 4.2% vs. 4.4% in September, the rate for 2025 has also been revised lower to 4.3% from 4.4%.

This means that the upcoming inflation data could sway the Fed more than the unemployment rate. FOMC members’ projections for rate cuts were also scaled back. The median expectation for interest rates in 2025 is 3.88% - 4.12%, the median estimate in September was between 3% - 3.6%. Thus, after today’s rate cut, FOMC members are only projecting 2 further rate cuts next year. The market is in unison with the Fed, and rates are only expected to fall to 4% by December 2025, down from an expectation that rates would end next year at 3.86% on Tuesday. Just two months ago, the market thought that rates would end next year at 3.3%.

Santa rally cut short for US stocks

The shift in expectations weighed heavily on US market sentiment. There were broad losses for US indices, the Dow Jones slipped 2.5%, extending its losing streak to 10 sessions, its longest losing streak since 1974. The Nasdaq fell by more than 3%, but the biggest loss was for the Russell 2000 index of mid cap stocks, which sank more than 4%. The Vix index, Wall Street’s fear gauge, surged higher, rising to its highest level since August. The dollar was the top performer in the G10 FX space on Wednesday. The dollar surged against the Kiwi dollar, which fell more than 2% on the back of the Fed meeting, the euro fell by more than 1.3% and the pound fell 1%. EUR/USD sunk below $1.05 and fell to its lowest level in 2 years. This pair has broken below its long-term range, which opens the way to parity. GBP/USD also reversed earlier gains and fell below $1.26, as global currencies faltered at the Fed’s renewed hawkishness.

The Fed statement did not pre-commit to future policy decisions, however, there were two notable lines in the statement accompanying the Fed’s rate decision. Firstly, ‘inflation remains somewhat elevated’, and secondly, that the FOMC remains ‘strongly committed’ to its dual mandate and returning inflation to 2%. Since it revised up its inflation expectations, that could put a lid on rate cuts for now. The Committee will look at the unemployment rate, the inflation rate and financial market conditions when it makes decisions. This suggests that rising equity markets could also hinder rate cuts.

Trump can’t save Tesla from the Fed

For now, the focus is on how much further will US stocks fall? This has been a sharp reversal, however the fact that the Dow has had its longest losing streak for 50 years is a sign that cyclicals and small cap stocks could be stretched to the downside. Instead, if the sell off continues, then tech stocks could be in focus on Thursday. All but one member of the Nasdaq 100 fell on Wednesday. Tesla was the weakest performer and was lower by 8%, which suggests that even links to the White House cannot protect you from the Fed. Broadcom, which rose 11% earlier this week on the back of a good earnings report, was also one of the weakest performers and was down by more than 6% on Wednesday.

Profitable tech stocks could be the first to recover

In the longer term, we see the mega cap tech stocks that are listed on the Nasdaq 100 as having the most resilience to rate cuts, especially those that are profitable, such as Nvidia. The chip maker fell by 1.4% on Wednesday, but was higher in the pre-market, which suggests that it could outperform the less profitable tech stocks like Tesla in the short term. Bitcoin, which has a strong positive correlation with the Nasdaq 100, fell $6,000 in the last 24 hours, although it is holding above $100,000.

The US stock market had been looking frothy, so this sell off could be just what the market needs. It could also allow people to get into US stocks at a better level and set the stage for another rally in January. However, we think that the more hawkish Fed outlook complicates the picture for cyclical and mid-cap US stocks, even though the growth outlook has been revised higher.

How concerned are the BOE with the UK’s growth downturn?

With the Fed meeting out of the way, the baton is now passed to the Bank of England. The past week has seen a troika of bad economic news for the UK. Firstly, GDP fell for October, secondly, wage growth shot higher and thirdly, inflation is also moving in the wrong direction. Annual headline inflation rose to 2.6% from 2.3% in November, which was mostly down to expected base effects. Service price inflation remained steady at 5% YoY; however, this is still far too high for the BOE to be comfortable with. Pay growth is another concern. Private sector pay growth was 5.4% YoY in October, which suggests that the consumer could thwart the BOE’s efforts to bring inflation back to the 2% target rate.

Growth undershot the BOE’s expected rate, while inflation overshot the BOE’s forecast for November, thus recent data has complicated the path for the BOE in the coming months. The market has recalibrated UK rate cut expectations this week and have removed one full rate cut for next year. The BOE is still expected to cut rates by 25bps in February. The BOE will not release their latest projections at their meeting on Thursday, instead they will release them in February. A lot can happen between now and then. The weak growth outlook could mean that inflation falls, and unemployment rises with a lag. While we don’t think that the BOE will stray too far from their fairly neutral line that UK interest rates will be lowered at a gradual pace, we will be watching out for any hint of dovishness that the growth outlook and the collapse in business and consumer confidence could lead to a faster pace of rate cuts next year, or a super-sized cut, which is something that arch hawk Catherine Mann has advocated.

Overall, the Fed is the main driver of markets on the last full week of trading for 2024. However, the BOE has the chance to calm the UK market, as the UK-German yield spread rises above 2%. This is to be expected: the ECB is set to cut rates at a much faster pace than the BOE. However, if the BOE does sound more dovish than the Fed on Thursday, it could be bad news for the pound, and good news for the UK bond market.