Recalibration
The month of February was a mixed bag in North America for investors from an asset class performance perspective. While equities continued their impressive upward march with the S&P 500 Index advancing by ~+5.2% and S&P TSX by ~+1.6%, the fixed income asset class bore the brunt of jump in bond yields on both sides of the border. The bond yields jumped by ~+35-43 basis points for the 2-year to10-year tenures across the yield curve in the US after the US inflation surprised to the upside and investors factored in that perhaps the expectations of number of interest rate cuts through the year are too optimistic. The jump in bond yields was relatively less pronounced on the Canadian side where bond yields jumped by ~+5-to-22 basis points across the 2-year to 10-year tenures. Inflation in the US declined to +3.1% in January (reported in February) from +3.4% in December (reported in January) but was higher than the expected +2.9%. Inflation in Canada declined to +2.9% in January (reported in February) from +3.4% in December (reported in January and was lower than the expected +3.3%.
At the beginning of the month, the Fed Funds Futures were implying rates to drop from +5.50% to +3.86% in the United States, suggesting ~6 rate cuts of 25 basis points each through the year. This was in contrast with the guidance from the Federal Reserve as indicated in the Federal Open Markets Committee’s (FOMC) dots plot, that indicated only about 3 rate cuts by the end of 2024 (See Figure 1). In other words, the expectations of the extent and speed of rate cuts baked in the Fed Funds Futures contracts implied the economy could experience a deep recession. Afterall, more rate cuts and at a faster pace would be required to support only if the economy was teetering under the weight of monetary tightening. On the contrary, the economic data had continued to suggest resilience even in the face of higher interest rates.
The equity markets, on the other hand, continued to trade on expectations of a soft landing and a benign inflation scenario as the most likely outcome through the year 2024. This, put together with better-than-expected results from the corporates in general during the fourth quarter earnings season ensured that the equity markets registered healthy gains during the month, in our view. While the economic data during the month of February remained mixed, we think the fixed income markets have recalibrated expectations from bearish economic outlook more reasonably and equity markets are baking in an incrementally more bullish outlook. By the end of February 2024, the US Feds Funds Futures were showing less aggressive positioning of implied rates of ~4.48% (see Figure 1) as of December 2024 meeting (i.e. ~3 rate cuts) and many wall street strategists had increased their year-end price targets for the S&P 500 index.
Figure 1: Implied rate – Fed Funds Futures and Federal Open Market Committee (FOMC) Dots median
Source: Bloomberg
We think the reduction in the gap of expectations baked in by the markets and guidance from the Federal Reserve without much turbulence in the capital markets was a welcome development for the investors. That said, given that the economic data remains mixed overall, and the market positioning has skewed towards bullish once again, economic datapoints hinting at either too strong or too weak an economy could end the goldilocks environment (neither too hot nor too cold) and bring about the volatility in the capital markets over the short-term. Over the medium-to-long-term, the fact that Central Banks are now looking to cut interest rates rather than increase and investors remain laser focused on the policy trajectory, makes for a strong case to remain constructive on the risk assets.
