Last week’s GDP report was, on the face of it, good for stocks: the US economy is exhibiting robust non-inflationary growth. The 3-month annualised rate for the core consumption deflator (ex-food & energy) eased to 1.52% in December. According to the December SEP, the Fed’s longer-run estimate of neutral real rates was still unchanged at +0.5%. The FOMC is therefore likelier to judge that policy is too restrictive.
But strong economic growth – combined with excessive government deficits – will continue to steepen the yield curve. The full-year general government deficit reached 9.2% of GDP in 2023, unprecedented outside of recessions during peacetime. The 30-year TIPS yield settled at 2.10% on Friday, ahead of 10-year (1.85%) and 5-year (1.78%) real yields.
There are two scenarios worth considering, one which is more constructive for the stock market, and the other less so:
- The more likely scenario – our base case – is that the Fed embarks on one or two cuts this year. Long-dated Treasury yields climb, but slowly, towards 5%, with growth remaining firm.
- Another scenario, less benign: the Fed delivers the rate cuts (five or six) that the market currently expects. In this case, the long end sells off aggressively. The real economy proves too strong to justify a protracted rate cutting cycle. Inflationary pressures resurface, and the Fed is forced to backtrack.
The rise in real incomes (wages & salaries, usual median weekly earnings, etc.) will support growth in 2024. Demand will remain strong. But the more the Federal Reserve cuts, the more exposed it leaves the US economy to supply shocks. There is not much margin for error, given the rise in freight rates and mounting tensions with Iran.
