By Matt Tourville, Investment Adviser
The Year in Review
While 2023 started out with relative uncertainty, it’s now clear that the US economy will finish the year in a strong, if perhaps slowing, fashion. Annualized Gross Domestic Product (GDP) for the 3rd quarter shows economic growth of 5.2%, the fastest rate since the 4th quarter of 2021. In addition, the closely watched monthly change in non-farm payrolls showed an increase of 199,000 jobs in November, beating many economists’ predictions by 17,000. Lastly, the unemployment rate fell to 3.7% in November, edging down from the previous 3 months.
One measure that economists monitor to observe recessionary tendencies is the Sahm Rule, which states that a recession has begun when the 3-month moving average unemployment rate exceeds the lowest 3-month average from the previous 12 months by more than half a percentage point. With the lowest 3-month average for this cycle at 3.5%, and the 3-month rolling average at 3.8%, we are currently still shy of the key 4.0% recession benchmark.
One potential downside in employment measures is the persistent number of unemployment claims, where current weekly filings (220,000) exceed the level that concerned economists during the last half of 2022. Continuing claims may also reveal signs of labor market weakness, as the November 17, 2023, report showed the highest level of extended unemployment since November of 2021.
Another key economic indicator is inflation, as measured by the Consumer Price Index (CPI). The November annual change in prices came at 3.1%, much lower than the peak rate of 9.1% in June of 2022. However, recent decreases in fuel prices have distorted the “headline” CPI number as the “core” CPI – which strips volatile food and energy costs from the calculation – showed a 4.0% year-over-year increase for November. Both numbers remain higher than the Federal Reserve’s 2.0% target rate.
So, what creates the connection between economic conditions and the markets? Federal Reserve Monetary Policy. Here’s why: The Federal Reserve Open Market Committee uses monetary policy via changes to the Fed Funds rate to help shape (and sometimes correct) certain economic conditions. The market, in turn, reacts, often swiftly, to any hint of tightening or loosening of that policy.
At 5.25%-5.50% target rate for Fed Funds, most market observers consider the current Fed policy as “restrictive” and likely to slow the economy in the future. Over the last several months, the market has begun to price in future cuts to the Fed Funds rate, anticipating the end of the Fed’s monetary tightening. With this week’s announcement by the Fed that they, too, see interest rate cuts in store for 2024, the market stroll towards lower future rates became a stampede. The dramatic shift in market sentiment has driven borrowing costs down in rapid fashion. For example, the 10-year treasury yield peaked at 4.99% on October 19th and as we went to print on this commentary, it sat at just 3.91%. That significant change reflects the market telegraphing that the Fed will begin easing its monetary policy soon by cutting rates in a meaningful way. Changes in Fed Funds futures shows that the market has dramatically changed its outlook for Fed Policy over the last two months. Earlier this fall, the market believed that the Fed would begin cutting rates in June 2024, while it now believes the first cuts will come in March, despite some recent comments by certain Fed Governors to the contrary. Similarly, the market projected the implied 2024 year-end Fed Funds at 4.78% previously, and it now prices that level to 3.83%, which would imply six quarter-point cuts in 2024.
All of this tells us the market believes that either inflation, growth, or both will slow in the near future, allowing the Fed to deliver on its expected rate cuts. However, with six implied cuts in 2024, the market expects three quarter-point cuts more than the Fed itself projects. Both of these things can be true: the Fed has concluded tightening for this cycle and is now pursuing loosening policy on the margin, and the market is too aggressive in its expectation for the degree of that loosening in the near term. When 2022 ended, the market priced the implied rate at the close of the final 2023 meeting at 4.59%, severely underestimating how restrictive the Fed remain over the course of the year. The question that will determine how the market performs in 2024 will be whether the market is similarly wrong in its prediction for next year. The two likely scenarios under which the Fed would cut its target rate next year: declaring victory over inflation or the onset of a recession. While the market may be overly optimistic in predicting rate reductions, either of those scenarios are likely to result in continued easing in 2024.
Ehlers is the joint marketing name of the following affiliated businesses (collectively, the “Affiliates”): Ehlers & Associates, Inc. (“EA”), a municipal advisor registered with the Municipal Securities Rulemaking Board (“MSRB”) and the Securities and Exchange Commission (“SEC”); Ehlers Investment Partners, LLC (“EIP”), an SEC registered investment adviser; and Bond Trust Services Corporation (“BTS”), holder of a limited banking charter issued by the State of Minnesota.
Where an activity requires registration as a municipal advisor pursuant to Section 15B of the Exchange Act of 1934 (Financial Management Planning and Debt Issuance & Management), such activity is or will be performed by EA; where an activity requires registration as an investment adviser pursuant to the Investment Advisers Act of 1940 (Investments and Treasury Management), such activity is or will be performed by EIP; and where an activity requires licensing as a bank pursuant to applicable state law (paying agent services shown under Debt Issuance & Management), such activity is or will be performed by BTS. Activities not requiring registration may be performed by any Affiliate.
This communication does not constitute an offer or solicitation for the purchase or sale of any investment (including without limitation, any municipal financial product, municipal security, or other security) or agreement with respect to any investment strategy or program. This communication is offered without charge to clients, friends, and prospective clients of the Affiliates as a source of general information about the services Ehlers provides. This communication is neither advice nor a recommendation by any Affiliate to any person with respect to any municipal financial product, municipal security, or other security, as such terms are defined pursuant to Section 15B of the Exchange Act of 1934 and rules of the MSRB. This communication does not constitute investment advice by any Affiliate that purports to meet the objectives or needs of any person pursuant to the Investment Advisers Act of 1940 or applicable state law.