12/23/2024

Markets are not going gently into the holiday season. Last Wednesday, the S&P 500 index recorded its second worst day of 2024, interest rates rose sharply and the VIX volatility index soared above 25 points. The reason for this, of course, was the Federal Reserve, which surprised the markets with an aggressive turnaround in its statement, in its projections, and in the communication of its chairman, Jerome Powell.

If we combine the Fed meeting with more moderate signals than expected by the Bank of England and the Bank of Japan, it is no surprise that the US dollar has strengthened as it did, breaking the range in which it had been operating for the last two years.

And what did the Fed say that was so surprising? Well, if we analyze it well, nothing that is not consistent with its data dependency policy. At first glance, the Fed's decision followed the market's expected script to the letter and cut rates by 25 basis points. However, Powell stressed that “we are at or near a point where it will be appropriate to slow the pace of future tightening.” The Chairman also pointed out that the Committee needs more evidence of deflation to consider future cuts. Similarly, the projections showed significantly higher inflation in 2025 and an expectation of just two additional rate cuts in the year as a whole.

Although the market reaction was furious, we do not see the Fed meeting as a turning point in the Fed's monetary policy. Indeed, the Fed has stated, both actively and passively, that its monetary policy moves are conditional on the macroeconomic evidence as it is released. Consequently, economic activity that remains very robust, as Powell repeatedly emphasized, a stabilized labor market and firmer inflation do not justify a rapid process of monetary easing, but a slower one.

In this regard, the market's nervousness in Wednesday's session can be interpreted as an overreaction in the opposite direction to the one we saw in September, when investors were euphoric in response to a more moderate communication from the Fed.

On the macroeconomic front, published indicators reaffirmed the outperformance of the U.S. economy compared to other geographies. Retail sales in November showed a solid monthly increase and the third estimate of third-quarter GDP was revised upward to 3.1% quarter-over-quarter annualized from 2.8% previously. In addition, healthy real personal spending growth in the month of November anticipates good fourth quarter GDP growth data, which the Atlanta Fed currently projects at another 3.1% quarter-over-quarter annualized. In addition, the composite PMI index accelerated to 56.6 points, indicating continued strong economic activity.

On the other hand, activity in the eurozone continues to show signs of weakness at the close of the year. The PMI indicators for December, although they came out somewhat above expectations, remained in the contraction zone, while other national surveys were also reversed. Economic weakness in Europe has favored further progress in disinflation, justifying a faster process of rate cuts by the ECB. Similarly, economic activity data in China also remain weak. Although there was a slight rebound in October, November data indicate moderation in retail sales growth and softer investment, with marginal growth in industrial production the only bright spot.

In sum, we do not see the Fed meeting as jeopardizing the 2025 scenario, as the institution merely followed its data-dependent approach. It is unrealistic to expect a systematic rate-cutting path in conjunction with activity and inflation data that remain highly resilient. However, the Fed's message does issue a cautionary note regarding the risk scenario posed by a Trump presidency in 2025.

Protectionist policies and, in general, the Republican's unpredictability create a breeding ground for volatility, in which recent investor complacency seems completely misplaced. In this regard, several Fed members acknowledged last week that they were beginning to incorporate expectations of higher tariffs into their inflation projections.

In addition to tariffs, the Fed could also face a more expansive fiscal policy. This week, Trump advocated a congressional deal to suspend the debt ceiling until January 2027, reflecting the new president's attitude toward fiscal discipline.