Quality bonds look set to gain further as economic growth moderates and rates fall, and their advance would likely be even more pronounced in the event of a hard landing. (UBS)

As of the end of trading on Wednesday, markets were implying a 76% probability that the Fed will ease policy at its March policy meeting, down from 96% at the start of the week. This appeared to contribute to a second straight daily decline in the S&P 500, the first time since 2015 that the index has kicked off the year with back-to-back falls. This was part of a broader risk-off move, with the small-cap Russell 2000 index experiencing its largest one-day fall since the March 2022 banking crisis. High yield credit spreads also widened, typically a sign of rising risk aversion.


But we believe the latest moves are largely a reflection of how far markets rallied in the final two months of 2023. We still expect Fed easing to support quality bonds and equities alike in 2024.


The latest Fed minutes, while indicating some caution over the pace of cuts, continued to back the view that easing is on the way this year. The overall tone of the minutes released on Wednesday was less dovish than Fed Chair Jerome Powell’s remarks at the press conference following the 13 December meeting, at which he pointed out that policymakers had started to discuss lowering rates. Among the more hawkish elements in the minutes, it was revealed that many policymakers felt that the swift fall in government bond yields, leading to an easing of financial conditions, “could make it more difficult for the Committee to reach its inflation goal.” However, such comments were balanced by the observation by a number of participants that “downside risks to the economy” would arise if rates were kept restrictive for too long.


In our view, the minutes were consistent with the Fed’s most recent dot plot, which indicated a median forecast among top policymakers for three 25-basis-point cuts in 2024. This is also in line with our view.


The most recent data point to a cooling labor market, lowering another barrier to policy easing. Inflation eased markedly in late 2023, with the Fed’s favorite measure—the core personal consumption expenditures index—rising just 0.1% in November on the month. There are also signs that demand for labor is moderating, which top policymakers have indicated will be crucial for hitting its 2% inflation target on a sustained basis. The JOLTS report, also released on Wednesday, showed job openings falling to 8.79 million, the lowest level since March 2021. The hiring rate declined to the lowest level since 2014, excluding the period around the onset of the COVID-19 pandemic in March and April 2020. Finally, the share of workers quitting their jobs fell to 2.2%, down from 2.4%. The fact that this is now below its pre-pandemic level may suggest that workers are becoming less confident in their ability to jump to better roles with higher pay.


Investors will be looking to the release on Friday of the December employment data for confirmation that the labor market is cooling. The consensus forecast is for a modest rise in the unemployment rate and a slowing of the growth in average earnings.


So, with rate cuts likely still ahead, we continue to see upside in fixed income. Quality bonds look set to gain further as economic growth moderates and rates fall, and their advance would likely be even more pronounced in the event of a hard landing. That said, markets continue to imply a faster pace of Fed easing than we anticipate, raising the risk of disappointment. As a result, investors can look for more attractive entry points given the potential for periodic rises in yields over the coming months. The prospect for rate cuts should also support stocks, though against a backdrop of more moderate growth, we continue to favor quality stocks—those issued by companies with strong balance sheets, high returns on invested capital, and a track record of delivering earnings.


Main contributors — Solita Marcelli, Mark Haefele, Christopher Swann, Vincent Heaney, Matthew Carter, Jennifer Stahmer


Read the original report: Markets start 2024 in a risk-off mood, 4 January 2024.