MIKE DOLAN: Holy trinity for 2024 markets requires some faith

London — With a rosy picture of stock and bond gains next year now the running consensus, forecasters are managing an impressive leap of faith over three main assumptions — soft economic landings, hefty interest rate cuts and above-target inflation.

Too good to be true?

Soft landings — at least in the broadest sense that may include moderate recession — seem a high bar after two years of brutal credit tightening. And yet, a holy grail for policymakers, such an outcome is now the glue that binds the upbeat forecasts and represents majority thinking among investors.

But perhaps the greater epiphany in annual outlooks is the idea that central banks will be easing rates substantially through the year even with inflation still above 2% goals. Disinflation, but really not of the immaculate sort — as the now-tired jibe runs.

For Europe’s biggest asset manager Amundi, for example, US and euro inflation will stay at 2.6% through next year — and remain above 2% in 2025. But it still thinks the Federal Reserve and European Central Bank will chop more than 100 basis points off rates in 2024 regardless.

“Inflation will remain just above targets, but the central banks will tolerate that outcome and start to ease anyway,” Amundi chief investment officer Vincent Mortier told reporters.

Deutsche Bank sees US inflation a bit lower at 2.1% next year, but still above target despite a forecast ‘mild’ recession — and it sees the Fed slashing rates by a whopping 175 basis point by the end of 2024.

There is of course an intensely debated and nuanced take on ebbing momentum in core inflation — a sense that post-pandemic supply-side bottlenecks are easing at last, and expectations remain sufficiently in check to allow central banks to reverse. What’s more, central banks can dial back borrowing rates but still leave them in relatively “restrictive” territory above long-term averages for longer, as per their newfound mantra.

Yet long-term market inflation expectations concur with the view that central banks may — quietly perhaps — just agree to live with slightly above-target inflation even as they insist otherwise, in part as a trade-off for dodging painful recession.

While relatively well behaved through the recent two-year inflation spike, five and 10-year inflation expectations embedded in the inflation-linked bond markets remain at 2.2%-2.3%. Five-year, five-year forward inflation-linked swaps are as high as 2.55%. The most recent Reuters poll of economists showed all 100 surveyed expect all the main measures of headline and core US inflation to remain above 2% at least until 2025.

Yet 90% said the Fed was done with hiking and almost 60% expected cuts to commence by midyear. In fact, almost a fifth of banks surveyed expect US policy rates to be cut to below 4.0% by next December from the current 5.25-5.50%.

To be sure, Fed policymakers themselves don’t see inflation back to target next year either — with their median core PCE gauge projection from the most recent quarterly forecasts at 2.6% through next year and still at 2.3% in 2025.

But neither has the Fed, rhetorically at least, taken another hike off the table yet and is only projecting one quarter-point rate cut at most by the end of 2024.

So what gives? Will almost sacrosanct central bank commitment to getting back to a promised land of 2% or lower inflation just be fudged at the last moment and quietly set aside?

Goldman Sachs’ US economist Jan Hatzius trumpets success in supply-side dynamics that will rein in central bank hawks, pointing to the fact that job openings have fallen without a significant rise in joblessness — as the so-called “Beveridge curve” might have suggested — and allowing wage growth to ease back without a major recession.

“Last year’s disinflation does indeed have further to run,” he said, characterising core inflation rates of 2-2.5% being “broadly consistent” with targets but also seeing just one quarter point rate cut next year.

“The most novel reason for optimism on growth is that because central banks don’t need a recession to bring inflation down, they will try hard to avoid one,” Hatzius wrote.

While Goldman may be one of the more cautious houses on the policy rate view, it is this hoped-for Fed pivot to the second of its mandates — to maximise employment — that likely encourages investors to look through rhetoric on a strict target.

Harking back to the banking crash and recession of 2008, economists David Blanchflower — a former Bank of England policymaker — and Alex Bryson studied the best leading indicators of an oncoming recession and pointed out how Fed policymakers were wide of the mark 15 years ago.

Fed meeting minutes from August 2008 suggested the central bank’s next move was likely to be tightening — a month before Lehman Brothers crashed, forcing the Fed to slash rates again to 0.25% from 2% and launch an unprecedented bond buying campaign.

What’s more, recent renewed buzz around the so-called “Sahm Rule” as a real-time US recession indicator is well founded judging by history, Blanchflower and Bryson say, and may be a better guide to a pivot than Fed statements.

Developed by Fed economist Claudia Sahm before the pandemic as a potential rule of thumb for triggering benefit payments, the formula suggests recession is under way when the three-month rolling average of the unemployment rate rises half a point above the low of the prior 12 months.

Right now, it is running as high as 0.33 of a point — its highest in 2½ years and up from near zero just six months ago.

If the Fed’s watching this as closely as markets seem to be, then next week’s November payrolls report may be an even bigger deal than usual and go some way to explaining some of the more aggressive rate cuts being pencilled in for next year. 

• The opinions expressed here are those of the author, a columnist for Reuters