Incorrectly timing rate cuts poses a significant risk, warn strategists at TS Lombard
As the market embarked on a robust “everything rally” fueled by high expectations of imminent interest rate reductions by the Federal Reserve to avert a recession, the risks of miscalculating the timing of these cuts are emphasized by Skylar Montgomery Koning and Andrea Cicione, strategists at GlobalData TS Lombard.
While investors may accurately gauge the scale of anticipated Fed rate cuts, the strategists caution that the peril lies in misjudging the timing. In a client note on Wednesday, they noted, “The market is an average of participants’ views and, caught between outcomes, appears to be pricing in a soft landing with ~140bp of cuts in 2024.”
GlobalData TS Lombard’s team contends that the approximately 200 basis points of rate cuts currently factored in for the entire easing cycle might be “too conservative rather than too aggressive,” especially in the event of an economic downturn.
The primary concern, however, revolves around the optimistic market movements anticipating an early batch of rate cuts in 2024. The strategists highlight the potential risk that the market might not witness the expected priced-in cuts, thereby reversing the 4Q23 trends of a weaker dollar, stronger fixed income, and enhanced equities.
In the fourth quarter, the Dow Jones Industrial Average (DJIA) surged, setting multiple record closes entering the new year. Similarly, the S&P 500 index (SPX) concluded Wednesday poised for its first record close in two years, according to Dow Jones Market Data.
In the fixed income sector, the 10-year Treasury yield (BX:TMUBMUSD10Y) retraced to around 4% in the new year after reaching a 16-year high of 5% in October. The prospect of sudden increases in borrowing costs for a substantial portion of the U.S. economy prompted a downturn in stocks, briefly erasing earlier gains in major U.S. bond benchmarks.
Despite the closely monitored Bloomberg U.S. Aggregate index boasting a 2.41% one-year return, with the iShares Core U.S. Aggregate Bond ETF (AGG) tracking a similar trajectory, the strategists caution of a potential sell-off if the market reevaluates Fed dovishness.
In the currency realm, the ICE U.S. dollar index (DXY), measuring the greenback against a basket of rival currencies, experienced a 3.5% decline over the past three months, per FactSet data. This decline occurred despite the dollar achieving its best first four days in a new year in nearly a decade.
While the dollar reached two-decade highs in 2022 during the Fed’s policy rate hikes, a shift toward rate cuts may lead to further weakening. The consensus anticipates a weaker dollar in 2024 due to substantial Fed cuts, with Koning and Cicione forecasting modest upside for the dollar. A weakened dollar can benefit major U.S. companies dependent on international sales, mitigating the impact of increased borrowing costs.
However, Fed rate cuts could also diminish the appeal of assets tied to the dollar for investors seeking yield.
