The Fed calls the top


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The Fed calls the top

It’s over. The Federal Reserve says the rate cycle has peaked. 

Perhaps Jay Powell, the Fed chair, did not state it with quite that level of finality. The phrase he favoured, repeated in several forms in yesterday’s press conference, was that the bank’s open market committee members “think it is not likely that it will be necessary to raise rates further”. But that is about as definitive a statement as a Federal Reserve chair, in their right mind and with one eye on history, is ever going to make.  

The message was reflected, too, in the Federal Open Market Committee’s summary of economic projections. The members’ aggregate expectation for the federal funds rate at the end of next year is 4.6 per cent, half a percentage point below what they expected back in September and implying three rate cuts next year. The pivot in the views of the individual members can be visualised this way: 

In September, a lone hawk believed rates would have to rise to 6 per cent by the end of next year. That hawk has flown, replaced by an outlier dove who thinks rates will fall below four. Meanwhile, a very strong consensus has consolidated around the 4.5 per cent level.

Powell’s press conference reinforced this picture. Asked if the aggregate expectation of three cuts in 2024 reflected anticipation of economic weakness, the chair replied that no, it reflected normalisation of growth and progress on all three major categories of inflation — goods, shelter and services. It was about as near as the temperate Powell has ever come to kvelling over the state of the economy.

More importantly, perhaps, Powell re-emphasized the familiar reasons for easing policy before inflation gets to a hard 2 per cent target by all main measures:

The reason you wouldn’t wait to get to 2 per cent to cut rates is that . . . it would be too late. You would want to be reducing restrictions on the economy well before 2 per cent, or before 2 per cent, so you don’t overshoot . . . it takes a while for policy to get into the economy.

It is hard not to interpret the statement, the summary of economic projections, and the press conference as together reflecting a desire not to repeat the mistake the Fed made at the beginning of this cycle — waiting too long to increase rates — by waiting too long to cut them. The Fed has pivoted, and is now clearly as focused on employment as it is on inflation.

The market, needless to say, lapped all this up. The Russell 2000, the small cap index that had been dragged lower by worries about rising default rates and iffy profitability, rose 3.5 per cent. The two-year Treasury yield leapt by 30 basis points.

The merry response, especially in short bonds, makes sense. But while the Fed’s shift in posture places an official benediction on a change in the economy that started several months ago, it is not an all-clear for the Santa rally to continue into 2024. The economy is still a fine balance. The risks of resurgent prices, on the one hand, and of growth slowing right into recession on the other do not disappear altogether because of the Fed’s new stance. And, as Unhedged has documented, there is enough optimism priced into the market that one can only wonder whether these twin risks are adequately priced in. Remember, for example, that the futures market had already priced in more than four 2024 cuts before yesterday’s meeting.  

Policy will remain uncertain, too. Powell was asked repeatedly to describe the thresholds that would trigger rate cuts. He repeatedly declined to answer, insisting that the committee had not yet discussed specifics. It is not, he emphasised, simply a matter or bringing rates down mechanically as inflation falls. He only indicated his comfort with allowing quantitative tightening to continue in the face of rate cuts, so long as the cuts were driven by falling inflation rather than signs of incipient recession. It may be wise for the Fed not to say too much on this topic, but investors have no choice but to speculate about what Powell & Co are thinking. 

Maybe there is a profits recession, after all

On Tuesday, we argued that the US is not in a profits recession, as some have alleged. Using the aggregate net income of S&P 500 companies as a proxy, and making some sane adjustments, it looks as if profits grew nicely between the second and third quarters, even when the big tech stocks are put to one side. The result is consistent with the national accounts data on corporate profits.

Gareth Williams, the head of corporate credit research at S&P Global Ratings, emailed to say we were wrong. He argued, first, that sequential improvement is too distorted by seasonal effects to be useful. Second, he said that his larger sample of both rated US companies (1,214 of them) and global ones (2,170 of them) shows something quite different than my snapshot of the S&P (importantly, his sample excludes financial companies, which might have anomalous responses to the shifting rate environment). He writes:

Global non-financial ebitda has contracted for 3 quarters in a row on a year-over-year basis, and in Q3 ebitda fell 4.4 per cent on an annual basis. Revenues are not yet contracting, but have flatlined. All regions have seen a decline, notably Asia-Pacific, where ebitda is down 7 per cent on an annual basis . . . It’s fair to say that North America has been the most resilient region, but even there we’ve had 2 negative quarterly year-over-year declines . . . It may have been a mild profits recession to date by historical standards, but it still is one.

His charts of North American profits: 

Measuring the total profitability of the corporate sector is a tricky, uncertain business. But Williams’ deep data set suggests that we should think about the asset valuations in the context of profit momentum that is, at best, sluggish.

One good read

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