The Fed's message to markets: Higher for longer and fewer rate cuts in 2024

DEWITT, Mich. - Sept. 26, 2023 - PRLog -- The Fed's new dot plot: One more rate hike left on the table, rate cut forecast reduced in 2024

Perhaps the key focus area for investors from last week's Fed meeting was the update to the "dot plot," or the FOMC's best estimate of where it sees the path of interest rates going. The median dot for 2023 remained at 5.6%, which implies perhaps one more rate hike is on the table, while the rest of the dots for 2024 - 2026 all shifted higher.

The Fed's updated economic projections: Are they being too optimistic on growth and the unemployment rate?

As noted, the Fed's updated set of projections also gave us its latest take on economic growth and the labor market, both of which were more optimistic than the June reading. This makes sense, given that the economy has held up much better than expectations more recently. However, the Fed's view of 2024 growth shows only modest cooling, to 1.5% annual growth, before rebounding to 1.8% in 2025. It also now sees the unemployment rate staying at 3.8% this year, and going no higher than 4.1% for the cycle, well below the 10-year average of 5.0% unemployment.

Markets react swiftly: Yields move higher, and stocks move lower

The primary reaction in markets has been an outsized move higher in Treasury yields and a swift move lower in stocks. With both the 2-year and 10-year U.S. Treasury yields hitting highs of this cycle after the Fed meeting, longer-duration parts of both fixed-income and equity markets have been the laggards in recent days.

Opportunities in the new higher-for-longer world

How should investors think about portfolios in this new "higher for longer" regime? While higher rates can put pressure on parts of the stock and bond market, they can also create opportunities for certain segments leveraged to higher yields.

• In equities, we would expect some broadening in leadership to emerge as rates remain elevated, and investors could look to complement growth and technology sectors with parts of the market that have more favorable valuations. Over time, cyclical sectors, like industrials and materials, and even small-cap and international stocks, may play some catch-up.
• In bonds, while the short-duration cash-like instruments are interesting at 5.0%+ yields, we would be weary of being too overweight cash. There could be reinvestment risk as the Fed pivots lower over time, and we see more attractive opportunities forming in the longer-duration investment-grade bond space. Historically, one of the best predictors of forward returns is current yields, and if the Fed is indicating it is close to a peak interest rate, this could be a favorable time for high-quality bonds.