Markets have apparently full-on embraced the prospect of a Santa Rally this year, with US stock indices scoring 6-year record growth over the last week. For forex traders, that means the dollar has been substantially on the backfoot as investors sell treasuries to buy into the stock market. The lower yields subsequently have hurt the dollar, while risk-on assets have been surging.
The main reason for the most recent boost to optimism is the recent Fed decision. Holding rates and forecasting as many as three rate cuts next year was cheered by markets. But, almost immediately, the Fed has come out to try to trim some of the “euphoria” of the markets. That’s because, once again, the markets are expecting more dovishness than the Fed wants to admit to.
Claiming Victory and Starting the Party
After months in which the Fed said it was likely to raise rates, but the markets didn’t believe them, it seems the markets were vindicated. The Fed hasn’t completely shut the door on a rate hike, but that is seen merely as a formality. The market projection that the Fed would ultimately be less dovish than it said it would seems to have convinced many traders that the Fed is now more talk than action on the tightening aspect.
Following the rate decision, the markets and the Fed are once again disagreeing where rates will go. The Fed says 3 rate cuts over the course of the next year, with those concentrated in the back end. The market says 5 rate cuts, starting as early as May. Investors seem to be placing their bets that the Fed will be wrong again. But that’s ignoring that the markets predicted that the Fed would taper off rates long before it actually did. Neither side has a proven record of forecasting the future. But that hasn’t stopped the parting in the markets, lately.
The Potential Downer for the Markets
Markets are betting on inflation coming down faster than currently anticipated. The latest update on that front will be on Friday, when the Fed’s preferred inflation measure comes out. Annual core PCE index is expected to tick down to 3.4% from 3.5% recorded in October. That’s hardly a big move.
On the monthly basis, there is some indication for stability. Economists are predicting that monthly core PCE will stay steady at 0.2%, the same as the prior month. That would imply a rate much closer to the Fed’s target. However, many investors have been saying the figure will likely underperform. That means there is a substantial risk of a surprise to the upside, as the optimism in the market recently implies already expecting a better result.
Getting the Forecasts in Order
Inflation and economic growth correlate, so slowing inflation at least warns of potentially the economy slowing down. The Fed’s GDPNow currently forecasts that the final quarter will have growth of 2.6%, half of the rate recorded in the third quarter.
While markets celebrate the potential of Fed rate cuts, history shows that they’ve only happened close to a significant drop in the market. As long as the data continues to be positive, the Santa Rally might be intact. Risk might stay on the menu. But after the party, a more sober look at the forecasts might lead to a correction and a resurgence in safe haven demand.
