Is rate cut mania justified?

U.S. stocks are experiencing a decline, influenced by indications that interest rates may have reached a bottom, at least temporarily, triggering a subtle reversal of the positive momentum seen in November when both equities and bonds made significant gains.

Last month’s bond rally and the tidal wave of dovish rates wagers may be indicative of a momentous shift in the market’s thinking; the move higher in 10-year US Treasury yields we are seeing today might just be marking a local bottom (at least for now) as investors assess positioning into December.

But frankly, market positioning can’t get any more dovish without concrete evidence to suggest that the US economy is on the verge of an equally epochal downdraft.

In an ideal world, rates would decline, inflation would return to target levels, corporate profitability would double, and prior interest rate hikes would have no adverse effects on demand or balance sheets. And as incredulous as that sounds, since Chris Waller’s game-changing remarks late last month, the market’s collective faith in a best-case 2024 conjuncture may have gotten too far over its skis on rate cuts mania.

While the growth outlook has moderated in recent weeks from the 5%+ pace we saw in 3Q23, the economy does not appear to be heading for the cliff edge in 2024, which — despite progress on inflation — might not compel the Fed to cut as aggressively as current market pricing might suggest.

We are not arguing that the prospects of slowing growth may require some Fed stimulus support via a few rate cuts. Indeed, the narrative since the summer of 2021 has predominantly centred on the Fed’s inflation mandate; recent indicators suggesting that inflation is coming under control have prompted a shift in market attention back to the Fed’s growth mandate. To be sure, unemployment in the US remains very low and 3Q GDP growth was robust. But trends can change.

Price action in the S&P 500 suggests rates-driven pressure on Tech and a bit of risk aversion under the surface as investor focus this week remains on macro releases as we get the November Payrolls report Friday — a key data point to assess if growth is holding up and whether rate cut mania is justified.

While downward adjustment in the 2024 dot seems necessary, there is a tightrope walk here. Officials will unlikely desire a scenario where the market pushes the rate cut expectations even further. It is evident that the market has and will quickly embed a heavy dose of rate cut expectation if economic data continues to cool, thinking Jerome Powell will swiftly respond with rate cuts to prevent the deceleration from evolving into a recession.

One of the issues we discussed last month was the market liquidity amid the FED QT heading into December.

The recent sharp increase in the Secured Overnight Financing Rate (SOFR) has caught the attention of market participants, especially those attuned to funding dynamics and liquidity trends.

The noteworthy 6 basis points jump in SOFR observed in Friday’s fix has raised eyebrows, especially considering it occurred after the month’s end. Such movements in interest rates, particularly in short-term funding rates like SOFR, can indicate liquidity conditions and funding availability shifts. A higher SOFR print may suggest tightening liquidity, making it more expensive for institutions to borrow in the overnight markets.

For those in tune with financial markets, this movement in SOFR could be viewed as evidence supporting the idea that the liquidity tide is receding or that conditions for obtaining funding are becoming less favourable. If this trend continues, one could expect more dialling for the dollar, a colloquial term used on trading desks to call other banks for direct offers on the US dollar.