Looking Towards Rate Cuts In 2024

The technology sector led a rebound in the major market averages yesterday, but there was not a lot of participation from the remaining sectors, and the Russell 2000 small-cap index closed modestly lower. There were no economic reports to trade on, which is why volume was relatively light. I expect more of the same until we finish the month of August. The pause to refresh continues.

When a soft landing for the US economy can be confirmed by Fed officials, which I think occurs during the first half of 2024, we should start to see a normalization of short-term rate policy. That means moving from the currently restrictive stance to one that is neutral, meaning rates are neither restrictive nor stimulative. While this may be a highly subjective number, Chairman Powell has suggested that it approximately 3.5%. The soft landing will come into view once the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) price index, which is the Fed’s preferred measure, fall close to the Fed’s target of 2%. Assuming the US economy avoids a recession between now and then, which is my base case, we will have our soft landing. I expect that a new all-time high for the S&P 500 before then will be the leading indicator.

Based on Fed funds futures, the consensus of investors is expecting the first rate cut at next year’s May meeting. That would lower the target rate from a range of 5.25-5.5% to 5.00-5.25%. I think rate cuts will start sooner than that, because I see the core rate of inflation falling faster than the consensus.

Shelter costs have been putting more upward pressure on core inflation than any other category and accounted for 90% of the CPI increase in the month of July. This is because it takes a full 12 months for new rental rates to work their way through the annualized number, which stands at approximately 8%. As the chart below clearly shows, when the newest rental rates are factored into the annualized number, we should see a precipitous fall in shelter inflation by May of next year. The market will anticipate the rate cuts to come, based on this disinflationary development, and the bull market should continue to broaden and mature between now and then as a result.

The inflation hawks are saber rattling about rising energy prices today, which they assert will force the Fed to keep rates higher for longer, if not continue to tighten monetary policy. First, the Fed’s focus is on the core rate, which excludes food and energy prices. Both are subject to dramatic price swings which the Fed has little control over. The movement in the price of oil over the short to intermediate term has more to do with the speculative activities of futures traders than real world supply and demand. Therefore, it is futile to try and manage it with monetary policy. Second, rising energy prices is a form of tighter monetary policy on consumption, which self resolves over time.

As this bull market broadens and strengthens, and sentiment gradually improves, I will become more keenly focused on what can go wrong rather than what is already going right. There is a big difference between a pause to refresh (3-5%), a correction (10% or more), and a bear market (20% or more). The first is an opportunity. The second is a more painful opportunity that requires more defensive action. The last necessitates a shift to wealth preservation. This still feels like a pause that has yet to complete itself. If the facts change, then so will my outlook.

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