Every December, we publish our predictions for the year ahead. We believe these predictions have at least a 1-in-3 probability of materializing – making them realistic, while not necessarily our base case, and a surprise relative to investor positioning.
2023 was full of revelations – some of which we got right and some we got wrong. We anticipated a surge in Bitcoin and the Bank of Japan’s (BOJ) shift away from yield curve control (YCC). Local EM debt also had a solid showing with 10 central banks cutting rates this year, but we did not quite reach the double-digit returns we had envisioned. Some things we got wrong, such as high yield spreads which did not widen. While the BOJ shifted away from YCC and Japanese Government Bond (JGB) yields rose, the Japanese Yen did not strengthen as we expected. Finally, the Fed did not pause in Q1 despite the turbulence in the banking system, but did pause in June before delivering what was likely the final rate hike in July.
Here are our 2024 predictions:
1. The Federal Reserve cuts rates by 250 bps
A Fed Funds rate of 2.75-3% (250bps below the current policy rate of 5.25-5.5%) would put the real rate at 1%, assuming inflation is at the Fed’s 2% target. In other words, as long as disinflation continues, the Fed can reduce the Fed Funds target while keeping the real policy rate restrictive, e.g., at or above the Fed’s estimate of long-term neutral (0.5%). There is every indication that inflation is not as ‘sticky’ as feared. The 3-month annualized run rate on core PCE (personal consumption expenditures) has fallen rapidly from 6.6% in December 2021 to 2.4% in the latest reading for October. Further, supply chains have eased (foreshadowing core goods deflation), gasoline prices have sunk lower as demand falls (foreshadowing commodities deflation) and we continue to see moderation in rents and wages (foreshadowing services disinflation). What should be remarkable about our rate cut prediction is not the magnitude of the easing, but the fact that it is NOT predicated on a recession.
2. U.S. Aggregate Bonds return 10-15%
A bond market yield of ~5% is a far better starting point today than the 1% yield at the end of 2020. A rally of about 80 bps is all that would be needed to add another 5% return to the 5% yield of the market currently. Given ongoing disinflation and the Fed’s recent dovish stance, it seems reasonable that bond market yields can fall by at least 80 bps – and perhaps a lot more. A rally of about 170 bps would generate a total return of 15%, resulting in the best calendar year for the U.S. bond market since 1995.
3. Japanese yen appreciates 30% from ¥150 to ¥105
One surprise in 2023 was that the BOJ managed to gradually unwind YCC and allow the 10-year JGB yield to drift from 0.2% to nearly 1.0%, yet the yen depreciated by 11% vs the U.S. dollar. If we are correct that the Fed will cut rates in 2024 and the BOJ will hike rates (for the first time since 2007), the yen could see its first sustained tailwind since 2007-2011. For the first time in decades, inflation is above 2% in Japan, wages are rising, and the official policy rate of -0.1% looks woefully outdated. Higher yields for Japanese investors in their domestic market and an oversold currency should encourage repatriation and a broader flow of funds into Japanese markets, thus pushing the currency higher.
4. Gasoline prices fall to $2.50 per gallon
Another surprise in 2023 was the round trip in oil. Optimism around China re-opening and OPEC cuts drove prices up to $95 a barrel in September, but waning demand and increasing U.S. shale production proved too much for the market to handle and sent prices back below $75. Looking ahead, it is difficult to see demand re-accelerating against a backdrop of a global slowdown. In a general election year, it is also difficult to envision the administration discouraging U.S. production. Any breakdown in OPEC+ coordination will lead to an even steeper decline in oil and, consequently, gas prices at the pump.
5. Emerging market sovereign credit rating upgrades exceed downgrades
Credit rating upgrades across the emerging markets is not what one would expect in the aftermath of several years of aggressive central bank tightening and a still challenged Chinese economy - or following another downgrade to U.S. Treasury debt by Fitch in August. But that is exactly what we are expecting. Emerging market central banks have navigated pandemic policy exceptionally well. They began raising interest rates a year before the developed market central banks and have begun cutting rates well ahead of the developed market central banks. Further, they have spent the last two decades funding themselves in local markets, building local market yield curves and establishing a core investor group led by their domestic pension funds and insurance companies, thus eliminating convertibility risk. We believe the rating agencies will continue to reward their monetary and fiscal discipline with upgrades.