Fed Pivot Bets Look Overdone as Bond Yields Jump

Treasury yields experienced an uptick, propelled by robust indicators in both employment and consumer sentiment. This development has triggered speculations that the anticipation of Federal Reserve rate cuts in the coming year might have been overly optimistic.

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Across Wall Street, the prevailing sentiment is that the current economic strength has alleviated investor concerns about an imminent recession, albeit temporarily. However, it also suggests that the Federal Reserve may need to maintain higher interest rates for an extended period. This realization disappoints traders who, at one point, were optimistic about the central bank pivoting as early as March. Swap contracts now reflect a reduced 40% probability of such a pivot, down from over 50% prior to the latest report.

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Contrary to a series of data indicating a slowdown in the job market, Friday's report revealed an unexpected increase in nonfarm payrolls by 199,000, a decline in the unemployment rate to 3.7%, and monthly wage growth surpassing estimates. Concurrently, another report indicated a sharp rebound in US consumer sentiment in early December, surpassing all forecasts. Households also scaled back their year-ahead inflation expectations by the most significant margin in 22 years.

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John Leiper at Titan Asset Management observed, “The US economy continues to perform well,” highlighting the reversal of the aggressive decline in US Treasury yields seen last month. This decline, already deemed excessive, is now being corrected, with bond yields experiencing an upswing. With the markets revising expectations and pricing out rate cuts for the next year, the sentiment of "higher-for-longer" is regaining prominence.

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US two-year yields surged by 12 basis points to 4.71%, leading to a strengthened dollar. The S&P 500 exhibited fluctuations after a tech-driven surge in the preceding session.

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Recent softening inflation and employment data convinced investors that the Federal Reserve has concluded its interest rate hikes, sparking speculation of potential cuts totaling at least 125 basis points over the next year. Federal Reserve officials are currently in a quiet period ahead of the upcoming policy meeting, which coincides with the release of fresh inflation data.

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Quincy Krosby at LPL Financial remarked, “The Fed has been stymied by better-than-expected data releases,” suggesting that as long as inflation continues to trend lower, the Fed is likely to maintain its current stance. However, if the latest report signifies sustained consumer spending, the Fed may need to adopt a more hawkish stance, emphasizing the challenges in their ongoing campaign to curb inflation.

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Brian Rose at UBS anticipates that, given the market's already incorporated expectations of significant rate cuts in 2024, the Fed may avoid sounding excessively dovish. Neil Dutta at Renaissance Macro Research dismissed recession concerns, emphasizing that the labor market is not the primary determinant of current monetary policy.

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Dutta noted an asymmetry in the Fed's policy reaction function, highlighting that stronger employment is less likely to deter a rate cut compared to weaker inflation, which could push the Fed towards further cuts. While a robust economy sets a ceiling on the extent of cuts, it does not preclude them entirely, reflecting a recalibration of policy.

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Bank of America Corp.'s Michael Hartnett predicts a challenging first quarter for stock markets in 2024 if bonds rally, signaling sluggish economic growth. He attributes the current equity gains to lower yields, but a further drop towards 3% could result in a "hard landing" for the economy. The narrative of "lower yields equal higher stocks" might reverse to "lower yields equal lower stocks," according to Hartnett.

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On the contrary, David Bailin, Citi Global Wealth’s chief investment officer and head of investments, sees stocks poised for further gains in 2024. He cites decreasing inflation, a resilient economy, and rebounding earnings as factors that will drive stocks higher. Bailin emphasizes the opportunity cost for investors holding onto cash and suggests that core 60/40 portfolios remain an attractive option as the US economy remains robust.