We expect a slower growth and cooling inflation environment will allow the Fed to gradually reduce rates next year, thus stabilizing real yields and potentially biasing them lower.
Investors and policymakers will scrutinize incoming growth and inflation data to determine whether the Federal Reserve (Fed) will raise rates once more this year; however, it is clear the Fed is nearing the end of this tightening cycle. As the Fed concludes its aggressive tightening campaign, and given how restrictive policy rates are, the focus for 2024 is how soon—and how fast—the Fed could begin cutting policy rates relative to the pace of inflation i.e., near-term real yields.
To be clear, higher (lower) near-term real rates are driven by tighter (looser) policy expectations, falling (rising) inflation expectations, or a combination of the two. For most of this tightening cycle, stocks have moved inverse to the rate of change in near-term real bond yields1. As highlighted, stocks have been able to march higher this year given the increase in real yields has slowed compared to the spike in real rates and sharp equity selloff in 2022.
This makes intuitive sense; when the Fed first began raising rates, investors and policymakers recognized a significant amount of tightening would be necessary to quell inflation. While policy expectations have continued to price higher for longer rates pushing 2-year real rates gradually higher, now that policy is sufficiently restrictive the scope for further increases in real rates appears limited.
Of course, real yields won’t explain all the move in equity prices. That said, higher real yields tend to be bad for stocks given the increase in the cost of capital in the economy. For equity investors, stabilization in real rates would allow stocks to price based on fundamentals. This could occur if the Fed reduces rates in-line with falling inflation next year, thereby keeping real rates stable and modestly restrictive for economic growth. If growth begins to falter, the Fed could cut rates more aggressively than the decline in inflation leading to falling real rates and easier policy conditions for growth, supportive for stocks.
We expect a slower growth and cooling inflation environment will allow the Fed to gradually reduce rates next year, thus stabilizing real yields and potentially biasing them lower. Given this a well-balanced allocation across reasonably priced stocks and core bonds seems appropriate.