Jay the Santa

FED’s change in tone
Destruction of “higher for longer”
Things less bright in the old continent

The last month of the year 2023 came to a cherry‑on‑the‑cake conclusion with markets roaring to new highs and ending the generally positive year with the across‑the‑board optimism. In the lead up to this final hurrah in December, the inflation has been edging down throughout the year after 2022 spike up, causing substantial share of market participants to expect less restrictive monetary policy waiting ahead. As these hopes have received some support from central bankers (especially in the US), financial markets continued with the adjustments in positioning expecting interest rates falling sometime next year.

With that in mind, developed markets’ stock index MSCI World has increased 4.8%, while emerging markets stocks’ index MSCI Emerging Markets has risen by 3.7%. During the same period yields on bonds have dropped sharply, with 10‑year US Treasury bond yields dropping to 3.87% (4.26% 1 month ago) and German 10‑year bond yields sinking to 2.02%, down from 2.44% a month ago.

FED’s change in tone

Probably the best Christmas gift to investors last year came early not from Santa, but from the central bank of the US (the Federal Reserve/FED) and its chairman Jerome “Jay” Powell, who has delivered one of the most pivotal commentaries of the year. While keeping the interest rates at a 22‑year high, the central bank has announced the revised projections for the 2024, showing 0.75% of cuts in interest rates planned for the 2024 year alone. The latter projection change came in with larger cuts than previously forecasted. To boot, the Federal Reserve’s chair Jerome Powell has shared an unusually optimistic tone to the markets, noting that the interest rates are likely at or close to peak. In response, the financial markets, which have been cautiously expecting this sort of change in tone by the FED, have reacted in unison optimism, as if to re‑adjust for the lower rates ahead. Bearing in mind the ongoing strength in the mainstream US economy, the hopes are up that the fall in inflation will not be accompanied by a severe slowdown in the US economic activity.

USD yield changes for selected maturities vs last month

Source: investing.com

Destruction of “higher for longer” means good for the markets

In the eyes of some more optimistic market participants, the FED announcement mentioned above marks not only just another regular central bank update to the markets, but the unusually strong message that the previously repeated mantra of “higher for longer” interest rates is no longer valid. If these market participants are correct, the financial markets should be positioning for the interest rates coming down more quickly than previously expected, thus affecting almost every single asset class in the financial markets. While most probably keeping these allegations in mind, S&P 500 futures have jumped almost 2% in a single trading session, while yields on 10‑year US Treasury bond have crashed through 4% from 4.15% to 3.95%. At the same time, currency markets have adjusted for lower USD rates ahead, with EUR/USD climbing (i.e. US dollar falling vs euro) almost 2%, while oil price increased, too.

Things are not that bright in Europe

While things have generally stayed rather optimistic looking from the US macroeconomic point of view, economic activity has largely continued a more subdued tone in the Euro Zone. The Euro Area Purchasing Manager’s Index (PMI), an indicator largely regarded as a close‑knit gauge of European economic activity, has declined more steeply than expected by market participants in December. As the flash S&P Global composite purchasing managers’ index fell to 47 from 47.6 a month ago (readings below 50 indicate decrease), it is evident the economic activity in the bloc is somewhat diminishing further with no clear signs of turning the corner just yet. Among the suspected factors influencing this shrinkage were inflation, high borrowing costs and reduced levels of international trade. Market participants have also kept a wary eye on the largest economy in the Euro zone – Germany – which recorded a negative growth of 0.1% in the 2023 Q3 after humming slowly throughout the year. The yields, though, have been dropping in the Euro area, too, as could be noted from the German Treasury Bund yield changes. With that said, some participants suggest European story is much more skewed toward economic recession than a falling inflation alone.

Market view

The financial markets have ended the year with an evident hope for lower interest rates in 2024 and appropriate swift adjustments in the asset prices to reflect that. While there are a lot of reasons to believe the inflation and interest rates, accordingly, will drop next year, we are staying wary of the fact just how deep the expected interest rate cuts are for the next year. Should central banks decide to take a more cautious path forward, some market participants may be tempted to adjust the most aggressive positioning.

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