Twixmas round up

As we move through the festive period there is still one theme that seems to be driving all asset classes: central bank pivots and most importantly the Fed. After a spate of weaker than expected inflation data before the holidays, the market is now expecting the Federal Reserve to cut interest rates by 25bps in March. According to CME Fedwatch there is a now a 72% chance of a March cut. One month ago, there was only a 28% chance of a March rate cut, which highlights how much the market has shifted its stance since the last Fed meeting two weeks’ ago. This has fuelled the “everything rally” that has led to the S&P 500 rising by nearly 5% in the last month and the dollar index has fallen nearly 2.4% in the past month. So, as we move towards the end of the year, the path of least resistance is for stronger US equities and a weaker dollar.

While this theme is still pervasive, it is worth noting that after such a strong rallying in the last two months, the markets are vulnerable to a pullback/ negative reaction to any disappointing economic news. This is not just relevant for stocks, EUR/USD is also above $1.11, and is at its highest level since July, while GBP/USD is also higher by more than 5.7% this year and is attempting to break through $1.28. The big rally in stocks, bonds and dollar crosses means that investors are now perfectly priced for the dream scenario: a soft landing with inflation continuing to fall and the economy avoiding a recession. US 10-year bond yields had been trading above 5% in mid-October, the 10-year yield is now at 3.81%. That decline in yields (bond yields move inversely to bond prices), has made the price of money cheaper, which is good news for stocks, and it has also weakened the dollar.

For some, this is too good to be true. The market is driving this rally based on the Federal Reserve press conference from 13th December. That was when the Fed chair Jay Powell sketched out the potential path for rate cuts in 2024 and presented a more dovish than expected dot plot. Since then, we have heard little from the Fed chair about what he thinks of the market reaction, however, the market has run with his words and already priced in six rate cuts for next year, with cuts starting in March. This makes for a very interesting 2024.

Of course, the market could be correct – there was a clear pivot from the Fed earlier this month, and the market had been caught somewhat unprepared in the lead up, with some expecting the Fed to maintain their fixation on high inflation. After what has been a tough couple of years for analysts to try and make predictions about financial markets, there is an expectation that 2024’s price action could be easier to predict. Of course, famous last words: the Fed could cut rates only to need to raise them again on the back of a supply chain problem, like we saw recently with blockages at the Panama Canal and ships having to be re-routed away from the Red Sea due to the threat of Houthi missile attacks, disrupting vital global supply chains. Added to this, there is another threat to financial markets next year: politics.

We all know that markets are terrible at pricing in political risk, but with 40% of the world’s population heading to the polls next year, including Taiwan, Russia, the UK and the US, there is the potential for plenty of volatility going forward. For example, current polls suggest that if Donald Trump was the Republican nominee, then he would edge Joe Biden in the Presidential race. We are obviously 11 months away from the US election, and a lot can change in that period. But, for now, the political risk that is in abundance this year is a good reminder that volatility could be right around the corner. While the US election is seen as the key political set piece for 2024, the Taiwanese election on Jan 13th could set the tone for US-China relations and is one to watch in the coming weeks.