Momentum may last until year end but how dogmatic will central banks be in 2024?

Monetary policy has done a good job: inflation is down. But even if central banks just keep rates stable for now, the truth is that the pressure is on as the effects of monetary policy continue to unfold. The main question now is if we will return to the ambitious inflation target of 2% or if central banks will tolerate for inflation to fluctuate between 3% and 4%. Meanwhile, we may be in for a year-end rally as markets pre-celebrate victory over inflation.

Last week, the Fed secured another victory in its effort to bring down inflation that fell to 3.2% surpassing expectations by 0.1%. Also core inflation edged lower month on month by 0.1%, also bringing unexpected welcome news. Going forward, the Fed will remain data-dependent which will make any major macro data release an occasion for markets to have big reactions. This means that bad news will continue to be good news for the time being, i.e. cooling job markets will be welcomed with applause by equity markets.

Most likely the Fed is going to hold rates where they are for now and watch the economy closely. The question is for how long and how literally they take their self-imposed target of 2%. What the Fed wants to avoid at any cost is a second wave of inflation which is why they said they stood ready for further hikes if need be. The risk is that the Fed will become dogmatic in its quest focusing on unemployment data that could end up triggering a proper recession considering that labor market data constitute lagging and not leading indicators.

QT may counteract bond yield declines going forward

Interest rates are just one part of the story though. Quantitative tightening is another. Interest rates may well have plateaued, but the Fed is also looking to reduce its balance sheet. Meanwhile the US government is pulling in the opposite direction engaging in fiscal expansion and increasing its fiscal deficit. This makes one wonder who will buy all the bonds that the government is planning to issue if the Fed is taking a step back? In addition, the Fed's disposal of bonds is likely to counteract the decline in bond yields in response to inflation retreats.

Bonds breathe a sigh of relief for now, growth titles pull ahead

Generally, bonds as an asset class have just been unburdened as a part of the inflation premium they had to carry lately was removed. In response, the entire yield curve shifted down with the short end moving more than the long end leading to a slight flattening. However, inversion still persists which means that inflation worries still weigh on the asset class.

Conversely, equities seem to be more preoccupied with the possibility of a slowdown and deflationary tendencies – if they are indeed worried at all. Latest moves saw growth titles soaring pre-celebrating potential rate cuts that may come next year. And following the “bad news is good news” logic, a slowdown (note: not a recession) means a more accommodative central bank stance. However, one needs to bear in mind that growth titles continue to gloss over a more mixed picture that only emerges when the seven mega tech caps are removed from performance

Emerging market bonds increasingly attractive

Still, the momentum unleashed last week could last until the end of the year. Equities stand to benefit more so they are preferable over bonds. Emerging market (EM) bonds look increasingly interesting because growth momentum has improved relative to developed markets and EM central banks are closer to easing. Plus, the dollar, whose strength tends to weigh on EM assets, has likely peaked as US yields have too.