The Fed's message to markets: Higher for longer and fewer rate cuts in 2024

Key Takeaways

• The Federal Reserve held its September meeting this past week, and the message from Jerome Powell was clear: The Fed will continue to keep rates elevated until inflation moves more convincingly toward 2.0%. The Fed held rates steady at 5.25% - 5.5% at this meeting but kept the option of an additional rate hike on the table, maintaining its outlook for a peak fed funds rate of 5.6%. The Fed's new set of projections also reduced the number of potential rate cuts in 2024, from 1.0% to 0.5% of cuts next year – implying that the elevated interest-rate environment may last longer than expected.
• The market was quick to react to this somewhat hawkish Fed outlook. Treasury yields moved sharply higher, as both the 2-year (which is more sensitive to moves in the fed funds rate) and 10-year yields moved to highs of this cycle, putting downward pressure on stock and bond returns. Longer-duration parts of the market, including technology and growth sectors, underperformed the broader market.
• In our view, while Powell and team may continue to signal that they are not done raising rates, there may be a confluence of factors that keep them on the sidelines. Inflation, and especially core inflation, continues to gradually move lower; the labor market has shown early signs of cooling; and the consumer, which has been the backbone of the economy, has been drawing down their excess savings and is now facing higher oil prices as well. While market volatility may remain elevated in the near term, particularly as we also navigate a potential government shutdown and ongoing UAW strikes, we would expect any pullbacks to be in line with normal corrections. Long-term investors can consider using volatility as an opportunity to add to or diversify portfolios.

The Fed's new dot plot: One more rate hike left on the table, rate cut forecast reduced in 2024

Perhaps the key focus area for investors from last week's Fed meeting was the update to the "dot plot," or the FOMC's best estimate of where it sees the path of interest rates going. The median dot for 2023 remained at 5.6%, which implies perhaps one more rate hike is on the table, while the rest of the dots for 2024 - 2026 all shifted higher. The Fed pulled back its estimate of rate cuts in 2024 from 100 basis points (1.0%) of cuts to just 50 basis points, although cuts in 2025 are still expected to be 120 basis points, followed by another 100 basis points in 2026, bringing the fed funds rate to under 3.0%.

Our take: We were expecting the Fed to continue to communicate that its job on inflation is not done, and keeping the additional rate hike on the table was a good way for the Fed to do this. Since last week's meeting, markets now expect the Fed to remain largely on hold, although the probability of a December hike has increased. The first rate cut is also now expected in July 2024, pushed out from the June rate cut priced in before the meeting.

In our view, the Fed's next move may depend more on the trajectory of the economy. While it now forecasts stronger growth in 2023 and 2024, if the consumer or broader economy does weaken, the Fed may decide to cut rates sooner or more than by just 50 basis points next year. If growth holds up and inflation continues to gradually ease, then we think the market's current view is credible, and over time the Fed will steadily normalize rates down toward a neutral level.

The Fed's updated economic projections: Are they being too optimistic on growth and the unemployment rate?

As noted, the Fed's updated set of projections also gave us its latest take on economic growth and the labor market, both of which were more optimistic than the June reading. This makes sense, given that the economy has held up much better than expectations more recently. However, the Fed's view of 2024 growth shows only modest cooling, to 1.5% annual growth, before rebounding to 1.8% in 2025. It also now sees the unemployment rate staying at 3.8% this year, and going no higher than 4.1% for the cycle, well below the 10-year average of 5.0% unemployment.

Our take: While the economy has held up well thus far, we see early signs of some easing in both consumption and the labor market. As summer travel season comes to an end, the consumer is facing an extended period of higher rates and tighter borrowing standards, oil prices are elevated, and excess savings post-pandemic have been largely drawn down. And although the job market remains solid, some early warning signs, like fewer job openings and lower quits rates, have emerged as well. While we would not expect a deep or prolonged downturn in the U.S., a period of below-trend growth may be likely. Perhaps the Fed has reflected this to some extent in its 2024 forecast of 1.5% growth, but it also may be likely that economic growth underperforms the Fed's newly upgraded projections.

Markets react swiftly: Yields move higher, and stocks move lower

The primary reaction in markets to the FOMC meeting has been an outsized move higher in Treasury yields and a swift move lower in stocks. With both the 2-year and 10-year U.S. Treasury yields hitting highs of this cycle after the Fed meeting, longer-duration parts of both fixed-income and equity markets have been the laggards in recent days. Historically, a rapid rise in yields has weighed particularly on higher valuation growth parts of the market, and this could continue in the near term.

Our take: For equities, the higher yields also come at a time when there was some concern around extended valuations, particularly in the large-cap technology space and among the "Magnificent 7" (Magnificent 7 stocks include AAPL, AMZN, GOOGL, META, MSFT, NVDA, TSLA). Investor enthusiasm around artificial intelligence (AI) initially drove these stocks higher, but valuations now seem more stretched, and they face the challenge of a higher-rate environment. In addition, markets have walls of worry to climb around a potential government shutdown and ongoing UAW strikes, which may create near-term uncertainty as well. Thus, as we make our way through the seasonally more volatile period of September and October, we may see some consolidation and profit-taking in stock markets, although we would not expect a pullback to extend beyond a normal correction.

Opportunities in the new higher-for-longer world

How should investors think about portfolios in this new "higher for longer" regime? While higher rates can put pressure on parts of the stock and bond market, they can also create opportunities for certain segments leveraged to higher yields.

• In equities, we would expect some broadening in leadership to emerge as rates remain elevated, and investors could look to complement growth and technology sectors with parts of the market that have more favorable valuations. Over time, cyclical sectors, like industrials and materials, and even small-cap and international stocks, may play some catch-up.
• In bonds, while the short-duration cash-like instruments are interesting at 5.0%+ yields, we would be weary of being too overweight cash. There could be reinvestment risk as the Fed pivots lower over time, and we see more attractive opportunities forming in the longer-duration investment-grade bond space. Historically, one of the best predictors of forward returns is current yields, and if the Fed is indicating it is close to a peak interest rate, this could be a favorable time for high-quality bonds. Not only do you lock-in better rates for longer, but you have the chance for price appreciation if and when the Fed pivots lower as well.

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