Too far, too fast? Investors may have been over-bullish on economy

December’s whipsaw opening shows investors may be concerned November’s epic rallies went too far, too fast in anticipating a near-perfect soft landing for the economy.

Wall Street kicked off this week with losses for stocks and bonds in a sign that traders’ aggressive pricing for early, rapid Federal Reserve rate cuts in 2024 may have overshot. 

“My gut says that the market has baked in slightly more than enough cuts for the strength of economic data for the U.S. right now,” said Amy Xie Patrick, head of income strategies at Pendal Group in Sydney. 

The reversal underscores the risks that investors face as they double down on bets that slowing growth and inflation will force the Fed to execute a policy pivot. It’s a trade that stands to pay off handsomely if rate cuts materialize — or backfire spectacularly if U.S. policymakers opt to keep borrowing costs higher for longer.

The rate-cut wagers yielded solid gains in November. A Bloomberg gauge of Treasuries jumped 3.5%, its biggest monthly advance since 2008. The 9.1% surge in the MSCI global equity index rivaled the rallies seen in 2020 — when central banks were dishing out stimulus to revive their economies in the midst of the pandemic.

The euphoria was largely driven by a sea change in expectations for Fed policy moves. Traders now see about a 70% chance the US central bank will cut rates in the first quarter, and have priced in as many as five, quarter-point reductions by the end of 2024. At the start of last week, they saw less than a 20% chance of a March reduction, with only three cuts fully priced in for next year.

Concerns are growing that markets may be in technically overbought conditions and extreme bullish positioning risk leaving traders exposed to corrections.

“Markets are approaching the limits of what can plausibly be priced without attaching material odds of a recession in the near term,” Goldman Sachs Group Inc. strategists including Praveen Korapaty wrote in a Dec. 1 note.

Pendal’s Xie Patrick is recalibrating her firm’s wagers to account for the growing risks. She trimmed long positions on Treasuries, shifted to neutral on US high-yield credit, and exited bets for the dollar to fall against the South Korean won and Brazilian real. 

“I just think about it in terms of risk-reward near-term,” she said. “There is room for a bit of pullback on all three, even if the Goldilocks narrative still applies to the macro backdrop.”

The S&P 500 fell Monday from the highest since March 2022, while the Nasdaq 100 dropped 1% amid a decline in megacaps. U.S. two-year yields slipped one basis point on Tuesday after jumping 10 basis points the previous day.

“The biggest near-term risk for the markets could simply be that after a phenomenal one-month rally, a period of consolidation may be a necessary breather,” said Jason Draho at UBS Global Wealth Management. “A lot of good news is priced in.”

KEY JOBS DATA

A slew of key jobs readings over the next few days will be closely watched for clues on the Fed’s next steps — and the figures may reignite volatility in the market.

For Morgan Stanley’s Michael Wilson, US stocks are set for a rocky end to the year. The strategist said December may bring “near-term volatility in both rates and equities” before more constructive seasonal trends as well as the “January effect” support equities next month. JPMorgan Chase & Co.’s Mislav Matejka said markets expecting a soft landing leave no room for error.

“Perhaps one should be contrarian yet again,” Matejka said.

Whether the economy settles in for a soft landing or spirals into something worse, both scenarios suggest lower rates are coming. That revives the risk that investors will get burned again should Fed Chair Jerome Powell deliver the sort of hawkish surprises that punctuated 2023. 

Markets on Friday brushed off Powell’s comments that it was “premature” to show confidence rate hikes are over and speculate that cuts are coming. But Monday’s reversals highlight that recent rallies make investors vulnerable should the Fed fail to validate the market’s expectations.

“We had a massive increase in interest rates that just haven’t totally hit the economy yet,” said Dana D’Auria at Envestnet Inc. “The market has a decent chance of slowing down next year. Does it mean it’s a massive crash? No, not necessarily. But I don’t advocate chasing after stocks and not being balanced in the way that you go to the market.”