Charts of the Month

CHART 1 – THE FED’S U-TURN

Whilst the Central Banks really pivoted in late 2022 (when they began providing many commercial banks and other parts of the financial system with liquidity support) they have only in recent weeks explicitly signalled the end of their rate hike cycles.

This is big news for markets, given how important financial conditions are in setting the tone for equities and most other asset classes.

At its December meeting, the Federal Reserve surprised investors by not only suggesting the rate hike cycle is over, but also forecasting a series of rate cuts in 2024. That’s a significant U-turn for policymakers who have spent two years arguing their sole focus is on quashing inflation.

Which begs the question, do they know something about the economy that the rest of us don’t?

The chart below helps to explain the Fed’s evolving stance. It shows how headline CPI inflation has been trending on an annualised basis over a 3 month rolling period. This measure excludes shelter CPI and is often preferred by the Fed (and market participants) because of the lagged nature of housing and rental costs in the official CPI statistics. For instance, whilst shelter CPI has been a big driver of higher inflation over the past 12 months, we know it will continue to ease sharply over the coming months.

As of November, CPI ex-shelter was contracting by 2.5% on a 3 month annualised basis, suggesting the US economy has recently entered into a period of mild deflation. This is what’s likely worrying the Fed. It may well prove to be a relatively short-lived trend within a broader, multi-year inflationary regime but, for now, it means lower bond yields and a generally constructive outlook for markets.

CHART 2 – A SOFTER DOLLAR AHEAD?

There’s a common perception that the value of the US dollar is intricately linked to Fed policy and that the end of a rate hiking cycle typically leads to a weaker US dollar.

Arguing in favour of a softer greenback is the fact most other major Central Banks (especially in Europe and UK) appear to be less dovish than the Fed. Whilst policymakers at the ECB and BoE have also suggested no more rate hikes are in the pipeline, they have been keen to stress any rate cuts remain a long way off. Furthermore, with Japan witnessing its first proper bout of inflation for several decades, there is intense speculation that the Bank of Japan may finally exit from its negative rate policy. This could well be another false dawn, but it would almost certainly drive the Yen higher at the expense of the dollar.

That said, there are several reasons why the US dollar should remain relatively well bid. The main one being that, in the grander scheme of things, there is currently little divergence in global monetary policies. Furthermore, with the UK and European economies barely growing, the relative strength of the US economy bodes well for the greenback. At the same time, the Chinese authorities have been stimulating more aggressively of late, creating a headwind for the Renminbi.

All told, this suggests the dollar is unlikely to make a major move up or down anytime soon but, providing it doesn’t spike higher, financial conditions should remain relatively supportive to broader risk assets.

CHART 3 – THE FED’S PIVOT SHOULD BOOST GOLD

Gold bullion can be an extremely emotive asset. Some investors label it a useless “pet rock”. Others view it as the ultimate store of value.

Looking at it more objectively, there have been few better performing markets than gold over the past 5 years, at least in risk-adjusted terms. As of 31^st December ’23, it had produced an annualised gain of 10% (in U$ terms) with a maximum drawdown of 21%. The FTSE All-World equity index has produced a slightly better return of 12% p.a. but with two approx. 30% drawdowns.

Despite its recent strength, the chart below suggests the outlook for bullion (and other precious metals) remains positive because, historically, the end of Fed rate hike cycles have sparked substantial gains in the gold price. These have ranged from 50-60% at the end of the 2000 and 2019 cycles to a near 200% surge between 2007 and 2011.

It will no doubt remain a controversial and, at times, frustrating investment but gold looks set to break out to much higher levels over the coming years.

CHART 4 – BRACE FOR A “FOMO” RALLY?

This is likely to be one of the most important charts to monitor over the coming weeks. It shows the total amount held in US money market funds so is a good proxy for general risk appetite and investor positioning.

As you can see, the balance has surged over the past year to a record U$6trn as many investors have been attracted to the decent yields being offered by cash and cash-like instruments; a direct result of the spike in interest rates since early 2022.

However, that trend is now reversing with money market and short-dated bond yields down significantly from their mid-October high. Whilst the returns from these low risk assets remain attractive in the context of the past decade or so, some investors could be tempted to switch their cash balances back into equities and other risk assets, given the prospect of higher returns.

After all, markets tend to be driven by “greed” and “fear” and these extreme money market balances suggest we haven’t yet seen the “greed” stage of this stock market rally play out.