Can fund selectors hold their nerve as markets jitter?

Markets are now pricing in just two rate cuts this year

Tom Eckett

Market sell-off graph

Fund selectors positioning portfolios for the long term face a challenging six months as the Federal Reserve grapples with stubborn inflation and a strong US economy.

Earlier this week, equities and bonds both sold off after US inflation surprised to the upside for the third time this year, leaving markets spooked about the Fed’s ability to cut rates. The Consumer Price Index (CPI) rose 3.5% year-on-year in March, ahead of market expectations of a 3.4% jump.

In response, markets cut the odds of a US rate cut from 60% to 12% while a July reduction plummeted to approximately 50%, despite being fully priced in before the print was announced.

Futures are now forecasting two rate reductions this year, the first time markets have priced in fewer cuts than the Fed which is signalling three.

The inflation print sent 10-year US Treasury yields to 4.54%, their highest level since mid-November and the sharpest one-day move since September 2022, according to Deutsche Bank.

“It is getting increasingly difficult to dismiss this as just a temporary bump and the major concern is that inflation is ending up sticky above the Fed’s target,” Jim Reid, head of global fundamental credit strategy at Deutsche Bank, said.

There are increasing echoes of late 2021 when it became apparent that the initial spike in inflation was proving persistent, which in turn laid the groundwork for much more hawkish policy from the Fed.”

Stubborn US inflation has been painful for the popular equal-weight play on US equities. While the Xtrackers S&P 500 Equal Weight UCITS ETF (XDEW) saw $2bn inflows last year, it posted its worst day in almost two months after the print announcement, falling 1.6%. The ‘magnificent seven’ fell just 0.2% over the same period.

Fund selectors must stay patient in the face of negative data. ‘Do not fight the Fed’ is a phrase often forgotten on Wall Street, however, with the US central bank’s forecast of three cuts, the mantra should be driving an investor’s asset allocation.

“The US economy is now in the latter stages of its expansion phase, with activity expected to slow significantly later in the year. That points to interest rate cuts,” Nikolay Markov, senior economist at Pictet Asset Management, said.

“Our model shows that the Fed's target rate could be reduced to 4.3% by end-2024, which corresponds to around 100 basis points of potential easing.”

With markets spooked by inflation, now may be an opportunity to start positioning for rate cuts. This includes reducing exposure to commodities and adding duration risk.

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