Do you believe in Santa Pause?

Excuse the seasonal pun – it relates to a crucial point for markets in 2023. US monetary policy is a big determinant of financial conditions, not just in the US, but across the world. Will the US Federal reserve pause its tightening cycle at or close to current interest rate levels? The markets certainly think so: they are pricing the peak level for the Federal funds rate at 4.84% just a shade above the current rate target ceiling of 4.5%. That expected peak has fallen by 15 bps over the last week with markets expecting rates to fall towards 4% by early 2024. By contrast, the Fed hiked rates last week and more importantly upped its projected rate for the end of 2023 to 5%.

The market’s optimism on interest rates reflects the better news on inflation with last week’s CPI release coming in lower for the second month running. The Fed recognises the good news in terms of lower prices for energy, goods generally and health care. Their pessimism reflects the labour market which remains remarkably tight – a topic we covered last week and the record gap between wage inflation for job switchers and job stayers. A differential that means that firms are being forced to raise pay for existing staff to avoid losing them to rivals.

This will be resolved one way or another: either the labour market will soften, vindicating the markets’ optimism or inflation will prove sticky, justifying higher rates from the Fed.

What does all this mean for markets? We can see a negative impact either way. If the US labour market weakens early next year and we head into recession, consumers will spend less, and profit margins will decline. 1% off margins equates to 11% lower corporate earnings for the S&P 500. If the labour market doesn’t weaken, the Fed will continue to tighten and that’s bad for markets too.

We hold to our view that risk assets will continue to sell off. We may be close to the end of the bear market, but 10% downside is a realistic prospect. That could represent a buying opportunity because we expect the recession to be short lived and mild. We shall see.