Hawkish US Fed remarks on interest rates dampen investor sentiment

Markets started 2024 in full risk-off approach. The sell-off in the S&P 500 in the first week was the largest since October, while US Treasury yields rallied and the US Dollar Index – a measure of the value of the greenback against a weighted basket of major currencies – was trading up more than 1 per cent.

As exuberant as markets were in the final months of 2023, the pullback at the start of this year has been equally steep.

January is typically seen as a hangover month for markets, following the Santa rally in December, when investors and traders rebalance their portfolios and close out positions to book profits accumulated in the fourth quarter of 2023. A lot of the upward momentum was driven by expectations of a more dovish US Federal Reserve.

Coming into the new year, it seems as though this script has flipped.

The changing expectation by the Fed – and, by extension, markets – has led to a steeper-than-expected sell-off in January thus far.

The most recent Federal Open Market Committee meeting minutes showed that while current Fed rates are “at or near their peak”, there remains an “unusually elevated degree of uncertainty”.

This suggests that expectations of a 75-basis point cut, which markets rallied behind in the final months of 2023, might be slightly premature.

The CME Fedwatch tool shows that there is a 95.3 per cent expectation of a no rate increase at the Fed’s meeting on January 30 and January 31. The probabilities have also slightly changed for Fed’s March 19 and March 20 meeting. Current probabilities show that a hold in March is priced in at 36.2 per cent, with a rate increase expected at 60.9 per cent.

While these numbers still favour a cut, they don’t look as convincing compared with expectations from a week ago: December 29 showed that the probability of a cut was as high as 73.4 per cent, with a hold priced in at 11.5 per cent.

Last week’s US non-farm payrolls report did not help Fed forecasting.

The report came in much hotter than expected after the US economy added 216,000 new jobs in December, well above estimates of 170,000 and more than November’s revised reading of 173,000. The unemployment rate was unchanged at 3.7 per cent, slightly below expectations of 3.8 per cent.

The better-than-expected report hit markets hard, resulting in a sell-off in equities and the US dollar and Treasury yields catching bids through Friday’s trading session.

A robust US labour market and near full employment scenario are expected to stoke inflation and give the Fed more time to delay its first rate cut of 2024. This means that Thursday’s US consumer price inflation print has become even more critical.

Expectations are for core annual CPI to come in at 3.8 per cent versus a previous reading of 4 per cent. The overall annual CPI print (including food and energy) is expected to grow to 3.2 per cent, from a previous reading of 3.1 per cent.

Friday’s Producer Price Index data could also stoke volatility in markets. December’s yearon-year PPI is expected to grow to 1.3 per cent versus a previous reading of 0.9 per cent.

Softer inflation numbers at the end of this week will slow the sell-off in equity and currency markets. However, the geopolitical situation would suggest prices are on the rise.

Continuing tension and disruptions in the Red Sea will filter into the price of shipping goods, with some estimates doubling the price of shipping goods since a year ago.

This will trickle into the CPI and PPI data and further escalations to these readings will lead to the continued weakness in equities.

Fourth-quarter earnings start this Friday. Overall, earnings are expected to have grown in the final quarter of 2023, which may bring short-term cheer to markets.

However, overall risk moods will be driven by the US data docket and Fed expectations.

Expectations of a 75-basis point cut could be premature as global economic uncertainty remains