The Patient Pause

It seems like we just can’t stop talking about the Federal Reserve (Fed). After an aggressive rate hiking campaign that we think ended last year, markets were expecting the Fed to start cutting interest rates as early as next month. But with an economy that continues to surprise to the upside, along with inflationary pressures that are still too hot, it seems it will still be a few months before we get any of those rate cuts.

And the bond market may have finally taken the hint. After numerous attempts to “front-run” rate cuts in 2024, the bond market is now taking a less aggressive stance on cuts than even the Fed has suggested. Even before the March Consumer Price Index (CPI) report, the bond market had been discounting the potential for rate cuts in 2024. Coming into the year, bond markets had penciled in nearly seven rate cuts for 2024, a number that we certainly disagreed with. Now markets are hoping for two, which we think is more reasonable. But with the recent string of higher-than-expected inflation prints, the Fed will likely take its time before cutting interest rates.

In the meantime, economic data continues to support a patient pause from the Fed, with this week’s housing data and last week’s regional Fed report as recent examples:

Highlights from the March New Home Sales Report

• Rising new home sales were concentrated in the south, but all regions posted gains as demand for homes is strong.
• Homebuilders will continue to satisfy demand as inventory of existing homes remains low.
• Consider DR Horton’s recent earnings call. Given the demand, the company boosted its fiscal outlook this year.
• New homes are still selling faster than before the pandemic, telling us that builders can’t keep up with demand given the current pace of construction. We should expect additional construction payrolls to support job growth this year.

Bottom Line: Demand for new homes remains strong as homebuilders with in-house mortgage companies entice buyers with below-market rates. Creative financing should elevate residential investment, supporting gross domestic product (GDP) growth for most of this year. In-house financing is just one example of how the economy may be less sensitive to monetary policy, likely frustrating the Fed.

Highlights from the April 17, 2024, Fed Beige Book

• Consumer spending barely increased overall, but reports were quite mixed across districts and spending categories.
• Businesses are still feeling a shortage of qualified business applicants, despite the recent uptick in unemployment.
• Wage growth is returning to historical averages. Cooler wage growth could be a catalyst for softer consumer spending during the rest of this year.
• Disruptions in the Red Sea and the collapse of Baltimore’s Key Bridge caused some shipping delays but so far, have not led to widespread price increases.

Bottom Line: Businesses were cautiously optimistic about the outlook in their commentaries on local economic conditions, giving the Fed some slack as the Fed will likely keep rates higher for longer. Businesses believe inflation will steadily slow, but it may take longer than originally expected. Profit margins may shrink in the coming months as businesses confess a weakening ability to pass cost increases on to the consumer.

Call to Action

Markets were right, in our opinion, to price out the aggressive rate-cutting cycle that was priced in to start the year, but as long as progress is made on inflation, we think the Fed can still cut rates this year without reigniting inflation concerns. Our base case is still two or three cuts this year, depending on inflation data. And despite the patient pause by the Fed, investors still seem optimistic about holding equities. LPL Research recommends staying invested and maintains a neutral tactical stance on equities. We expect some volatility in the near term, but equity markets could experience a positive catalyst as the Fed cuts rates later this year and businesses keep healthy balance sheets.