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#65 - Don't Fall for the Sirens Too Early

Yesterday's FOMC meeting presented a notable Christmas gift for bulls. The Fed left the policy rate unchanged, aligning with expectations, but delivered what many perceive as a surprisingly dovish stance.

Indeed, Fed Chair Jay Powell indicated that the committee discussed potential rate cuts in the future, a point he hadn't mentioned just a few weeks prior. The December Summary of Economic Projections (SEP) now forecasts a median of three 25 basis point cuts in 2024, compared to just one cut in the September SEP.

However, the market had already priced in over 100 basis points of rate cuts for 2024 before the announcement, so why the strong market reaction?

Three reasons are particularly notable: Firstly, the market has received a clear message that we've reached the peak of interest rates. With the recent sharp decline in inflation, the real policy rate is effectively tightening without further action from the Fed. The forecasted cuts likely reflect the Fed's reluctance to further tighten the real policy rate, given the longer monetary policy lags in the current cycle. While this shouldn't have been surprising, Powell's confirmation appears to have bolstered bullish sentiment.

Secondly, the Fed seems to have lost some credibility in guiding the market. Despite successfully reducing inflation without triggering a recession, the market appears skeptical of the Fed's ability to achieve a 'soft landing,' as it officially forecasts. There's an expectation that the Fed will need to cut rates as rapidly as it raised them to combat inflation. Although the updated dot plot didn't confirm the market's aggressive rate cut expectations for 2024, the addition of two more cuts was perceived as dovish, prompting the market to price in even more cuts.

Thirdly, market positioning likely played a significant role. As highlighted in our CFTC updates (see latest report),  leveraged money was heavily short on S&P 500 and U.S. Treasury futures before the last FOMC meeting, leaving them vulnerable to a squeeze. Moreover, the long USD positions, especially against the Yen, were among the highest in recent years. The risk of a squeeze was particularly high, compounded by typically lower liquidity at this time of year.

This squeeze seems to have now materialized in bonds, equities, and the US dollar. Our total momentum score for US equities has hit the maximum of 10 (extreme overbought). This doesn't necessarily imply a sharp decline in equities but suggests that better opportunities may arise to take long positions.

Bottom Line:

Risk markets tend to perform well after the final rate hike, as we've previously discussed (see report). While the market has largely adhered to this pattern, it now seems excessively bullish following yesterday's FOMC meeting. Positioning, rather than a dovish surprise, may have been the crucial driver. Our momentum score is signaling strong caution for equities, bonds, and the US dollar.

Although the Fed might reduce rates next year, this isn't the opportune time to pursue rallies in equities and bonds.

Good luck

Team MacrometR


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