Total Eclipse of the Fed

Market Recap

• Equity markets were mixed this week alongside a heavy dose of economic data and Federal Reserve commentary. The S&P 500 dipped 1.0%, with health care, consumer staples and banks posting the deepest declines, while energy and telecom outperformed.
• Indeed, it was a strong week for resource stocks with oil and gold prices now making big runs. WTI oil prices pushed above $86, now up more than 20% since the start of the year, while gold has rallied 13%.
• This is, of course, music to the ears of the TSX which outperformed this week, up 0.4%. Materials and energy posted strong gains of 5.4% and 3.3%, respectively.

The Fed

Last week, U.S. Federal Reserve Chairman Jerome Powell delivered remarks at Stanford University’s Business, Government and Society Forum. While Powell did not provide any concrete answers on the timing of expected interest rate cuts, the speech did continue to give people hope that rate cuts are coming. Importantly, the comments were consistent with the central bank’s previous statements about inflation: it’s come down from worrisome highs, but it hasn’t yet reached the Fed’s target, which means that they aren’t quite ready to pull the trigger on rate cuts just yet. That reminder—that cuts are likely coming, just not necessarily immediately—should cause increased volatility. In our view, Powell may be gently guiding the market toward a two-cut scenario rather than the previously-expected three before year’s end. He can’t say that explicitly, however, because the Fed is waiting to see how the inflation numbers will play out.

Bottom Line: The overriding theme of Powell’s speech was that rate hikes are done and rate cuts are being seriously considered—it’s just a matter of inflation getting down into the Fed’s comfort zone.

Stocks & Bonds

What impact are Powell’s comments having on stock and bond markets? Equity markets, for their part, had typically ignored the Fed this year—they believed that rate cuts were coming and that they would effectively lower the expensiveness of stocks. However, the potential loss of a third rate cute in 2024 is meaningful to investors and has resulted in a small uptick in market volatility. Until rate cuts come to fruition, it’s hard to see equity markets moving much higher (given the already strong run-up) unless there is another catalyst like better-than-expected earnings. On the bond side, our takeaway from Powell’s remarks is that fixed income markets are likely to lag behind cash until they get a stronger signal that rate cuts are imminent. The spreads on High Yield bonds had narrowed a fair bit over the year and look expensive, especially as small cracks start to form in the economy. So far, with the economy having held up well, lower credit bonds have outperformed higher credit bonds. But going forward, with inflation coming under control and the economy entering a slow softening mode, we prefer to be a bit more quality-focused

Bottom Line: Both equity and bond markets appear to be in a temporary holding pattern as they wait for a sure sign that rate cuts are coming.

Gold

Gold prices picked up slightly in the wake of Powell’s speech, which may seem counter-intuitive if you interpret the comments as a generally good sign for equities over the year, as we do. It does fit a pattern we’ve noticed recently, however, which is that gold isn’t behaving exactly like it has in the past. For instance, gold typically would have been expected to weaken when the U.S. dollar strengthened, but that didn’t happen—it actually hit all-time highs. In our view, the explanation is that the supply-demand dynamics are becoming more fragmented. Some investors are holding gold as a reserve currency because they’ve seen central banks around the world increase their exposure to it. Others are holding it as an inflation hedge. And finally, some are holding it as a safe haven asset in case the economy weakens and volatility increases. These factors help to explain gold’s continuing momentum even after Powell’s remarks.

Bottom Line: Gold isn’t behaving as we might expect it to, as investors continue to hold it for various reasons and in spite of Powell’s recent comments.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled The Bulls Keep Running: Why Markets Remain Upbeat.

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Originally Posted April 8, 2024 – Total Eclipse of the Fed

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