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In 2024, Expect Lower Interest Rates & Lower Inflation

As we entered 2023, households were still flush with the cash from government handouts, the economy was healthy, the federal government was still running a significant deficit, and interest rates, while rising, had not yet been restrictive long enough to slow the economy. Real (inflation adjusted) GDP grew at an annualized rate of 3.0% for the first three quarters of 2023, and the Atlanta Fed’s GDP Now forecast is for a 2.3% growth rate in Q4. Hence, the year’s growth as a whole is going to be somewhere around 2.8%.

Equity values went on a tear, with the S&P 500 up more than +24% for the year. This is a little deceiving, as the S&P 500 is a capitalization weighted index, meaning the larger companies have more weight; thus the Magnificent 7 had a large role in that +24%. The equal weighted index (each company in the index has the same weight) rose 12; less so without the Magnificent 7.         

The 10-Year Treasury Bond entered the year at a 3.8% yield. It peaked at 5% in mid-October, and is leaving 2023 at a yield near where it began, just north of 3.8%; a round trip for the year as a whole (see chart).

Even headline inflation fell from 6.4% last December (2022) to 3.1% (as of November). Its peak was nearly 9% in June ’22. Better yet, its three-month trend is 2.16%. The November reading on the PCE Deflator, the index the Fed relies on, fell -0.1%, the first decline in more than 3.5 years. On a year over year basis, that index stood at +2.6%, but the really good news is that the six-month annualized rate is +2.0% and the three month is a scant +1.4%. One can see the progress by looking at the table.

Annualized Rates of Change

 Year/YearSix-MonthThree Month
Headline PCE2.6%2.0%1.4%
Core PCE3.2%1.9%2.2%
Super Core PCE3.5%2.7%2.9%

Note: “Core” is Headline ex-food and energy; “Super Core” is Services ex-rent and energy.

As is apparent, inflation continues to decline. Going forward, tighter fiscal policy in 2024 will exert further downward pressure. At the same time, the lagged impacts from the Fed’s prior tightenings will have a larger impact than they had in 2023. Let us note here that we believe that those monetary policy lags have been longer in this cycle than history would indicate because most consumers and businesses had locked in ultra-low rates during the prior decade of a near 0% Federal Funds Rate. As a result, in 2023, the economy was much less sensitive to rising rates than history would lead the economics profession to believe.

Consumption in 2024 will look far different from that of 2023 now that the consumers’ “excess savings” (cash from government gifts) has been spent.

As we have discussed in many past blogs, BLS uses a lagged rent series in calculating CPI. Rents have a 35% weight in the Index. Rents peaked in mid-2022 (see chart), have been falling since, and have been negative on a year over year basis since mid-2023. Those falling rents are going to be quite influential in the CPI throughout 2024. This is yet another factor in our view that inflation will continue to fall, perhaps even showing some deflation by year’s end.

Incoming Data

  • The Conference Board’s Leading Economic Indicators have been negative for 20 months in a row (see chart). History tells us that when this many negative months in a row occur, a Recession occurs 100% of the time. Will this time be different? Possibly, but we wouldn’t bet on that outcome.
  • Business bankruptcy filings are up nearly 40% from a year ago. Granted, 2022 was a low bankruptcy year, so there are some base effects here pushing up the percentage, but, clearly, businesses are not as healthy as they have been over the last three years.
  • As we have noted in past blogs, auto and credit card delinquencies are high and rising, usually a sign of trouble and an historic precursor to a tail off in the consumption numbers that are key to GDP growth.
  • Housing, a very significant component of GDP, is in decline due to high interest rates. The right side of the chart shows the plunge in Existing Home Sales as the Fed raised rates. The left side shows a subdued path of new home sales in 2023 with a significant tail off in October and November.
  • In addition, Pending Home Sales, contracts signed but not yet closed, fell in November to record low levels (see chart below). So, the Fed’s interest rate hikes are now having significant impacts.
  • Worse, the University of Michigan’s consumer sentiment indicators for auto, home, and large household purchases are at or significantly below levels of prior Recessions.
  • The 10-Year Treasury closed the year at a 3.87% yield. Fed Funds were 5.25% – 5.50%. The gap between the two is 138 to 163 basis points. According to Rosenberg Research, the last time there was such a gap was 2001. By June 2003, the 10-Year yield fell by 212 basis points, and its return over that period was an amazing +32%. So far in this cycle, the yield has fallen 113 basis points. In any case, even if there is a “soft-landing,” the Fed has to go to neutral (2.5% according to Powell), over the next 12-18 months. So, the outlook for the 10 year is an additional reduction of at least 100 to 150 basis points from current levels.

Final Thoughts

  1. We were early on our Recession call, saying it would start in 2023. The fact that it didn’t occur in that time frame doesn’t mean it is cancelled – just delayed. The real issue here continues to be its magnitude and duration.
  • 2023 turned out to be one of the best years for equities this century. We doubt that will be repeated in 2024. Investors should be cognizant that the current market hasn’t seen a “correction” in more than a year. The real question is the timing and magnitude of that market pullback. If there is a “soft-landing,” then any correction will be mild and likely short-lived. If there is a Recession, markets will react negatively, with the magnitude of the pullback highly correlated with the depth and duration of the Recession.
  • Interest Rates, we believe, have further to fall. Even in a soft-landing scenario, the Fed will need to push rates down at least to neutral, which they have defined at 2.5%. That’s 275 to 300 basis points lower than their current 5.25%-5.50% Fed Funds Rate. Over the last couple of months, the fixed-income market has anticipated this, and market rates (including mortgage rates) have fallen. Because of our economic outlook, we believe that interest rates have further to fall.

Robert Barone, Ph.D.

(Joshua Barone and Eugene Hoover contributed to this blog.)

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