Looser Financial Conditions Leading to Uncertainty for the Federal Reserve

The overall positive sentiment in the markets as we approach the end of 2023 may not align with the Federal Reserve's expectations for the holiday season. December has seen the stock market once again approaching record levels, driven by optimism regarding easing inflation and potential rate cuts by the Fed in the coming year.

While double-digit equity gains would offer some relief to investors after the challenges of 2022, this recent rally also indicates looser financial conditions. However, there is a potential risk associated with these looser conditions, especially if they conflict with the Fed's objective of maintaining restrictive credit until inflation is effectively controlled.

In particular, the November rally for the S&P 500 index can be attributed to the drop in the 10-year Treasury yield. After reaching a 16-year peak of 5% in October, it fell to 4.1% in November. Although the Fed has direct control over short-term rates, the 10-year and 30-year Treasury yields play a significant role as benchmarks for pricing auto loans, corporate debt, and mortgages.

Consequently, long-term rates have substantial implications for investors in stocks, bonds, and other assets. Higher rates can lead to increased defaults and can also hinder corporate earnings, growth, and ultimately impact the overall U.S. economy.

Michael Pearce, lead U.S. economist at Oxford Economics, believes that the November rally may create a challenging situation for Fed officials ahead of the upcoming December 12-13 Federal Open Market Committee meeting. This meeting marks the eighth and final policy gathering of 2023.

"The decline in yields and surge in equity prices more than fully reverses the tightening of conditions observed since the September FOMC meeting," Pearce noted in his Thursday client note.

Although the current rally is offering some respite to investors, it also introduces uncertainties for the Federal Reserve as they strategize their approach in maintaining financial stability while striving to control inflation effectively.

The Federal Reserve's Next Steps

The Federal Reserve (Fed), in its upcoming meeting, is anticipated to maintain its benchmark interest rate at a 22-year high within the range of 5.25% to 5.5%. This decision to keep rates steady was initially established in July, with the objective of curbing inflation and reaching the central bank's target of 2% annually.

During the lead-up to the July meeting, the stock market experienced a surge driven by the impressive performance of six mega-cap technology companies and the widespread optimism surrounding artificial intelligence (AI).

June Update: Nvidia enters the trillion-dollar market-cap club, joining an exclusive group of seven U.S. companies that have achieved this significant milestone.

In September, the Fed opted to maintain rates at their current level. However, central bankers emphasized their intention to sustain higher rates for a more extended period during this meeting. Previously projected as four rate cuts in 2024, they adjusted their forecast to only two cuts. This unexpected announcement unsettled the markets and subsequently led to monthly declines in stocks.

According to Pearce, an industry expert, he predicts that the Fed will challenge the notion of possible rate cuts in the near future while erring on the side of maintaining high rates for an extended period.

As it stands, market odds indicate a 52.8% chance of the first rate cut occurring in March, but Pearce suggests a September timeline for this adjustment, differing from popular expectations.

On Thursday, stocks showed signs of recovery and were on track to end a three-session decline. The previous day, the S&P 500 index closed at 5.2% below its record high achieved almost two years ago, while the Dow Jones Industrial Average (DJIA) remained merely 2% away from its peak close. Additionally, the Nasdaq Composite Index (COMP) was nearly 12% lower than its November 2021 record, according to Dow Jones Market Data.

Related: What investors can anticipate for 2024 following a two-year struggle in the bond market.