Investment Strategy Brief:
Looking Ahead to 2024

Below is a transcript of this week’s video.

Hello, this is Ilona Vovk with Investment Strategy at Glenmede.

The Federal Open Market Committee will meet this week and market expectations, as measured by the pricing of fed funds futures contracts, are currently implying a near-100% probability for another pause in rate hikes. With that said, the cumulative impact of rate hikes over the past year and a half has caused a meaningful spike in the cost of capital.

At this point, the fed funds rate remains meaningfully above the neutral level. It may also be helpful to take a step back and see the bigger picture. The result of more than a year of aggressive rate hikes has led to considerably tight monetary policy. In the past, when the fed funds rate was materially over the neutral rate, that has often started the clock for an economic recession in the U.S. Aggressive tightening preceded recessions, which tended to show up 12-24 months after that point. Why the lag? It often takes time for monetary policy to permeate into the economy, often in the form of higher borrowing rates and reduced demand.

Now, the Fed is expected to maintain tight monetary policy for the next few years, moderating to normal as long as inflation remains contained. The Fed’s own projections from its dot plot suggest that rates above neutral are the base case by the end of each of the next three years (including 2023). And, to a similar end, the ongoing normalization of the Fed’s balance sheet is likely to continue until pre-pandemic levels of reserves as a share of GDP are reached, which likely won’t occur until 2025 at this pace.

It’s also important to look at the decade plus following the Great Financial Crisis of ‘08/’09, where the environment was dominated by ultra-low interest rates and large-scale bond buying by major developed central banks and the Fed was certainly no exception. But that party appears to have come to a close with a new era of higher rates not seen since the turn of the millennium. This means that we are now in an environment with a credible cost of capital after years of easy money.

This all contributes to meaningfully tight financial conditions. The Fed's Financial Conditions Impulse index seeks to measure the influence on real GDP growth exerted by financial conditions. It sat at an all-time high in the post-pandemic period when the economy improved from lockdowns and interest rates sat at all-time lows. Since then, financial conditions have tightened considerably.

In addition, the sustained “higher for longer” interest rate policy from the Fed should eventually bleed through into higher debt costs for corporations. Over time, as new debt is issued and existing debt is rolled into new loans, those debt costs should gradually rise over time, but gradual is the operative word there. Only a fraction of outstanding corporate debt is scheduled to come due in 2024. Those higher rates should incrementally dig into profit margins, but that’s likely to be a factor that plays out over the next several years. Now on the consumer end, the effect of rates can be seem by the difference between the effective interest rate of mortgages outstanding compared to the current 30-year fixed mortgage rate, where the current rate is at a relative all-time high. What does this mean? Well, the last time we saw this was in the early 1980’s and that wasn’t when home prices were at an all-time high like they are now. Secondly, current homeowners that locked in historically low rates are unlikely to leave their homes, putting further pressure on prices with a lack of additional supply entering the market. But again, those who have locked in a lower rate are not likely to feel the impact immediately, it will take time as well.

The biggest implication of the new interest rate regime is that the longer that financial conditions stay tight, the more pressure the broader economy faces.

To summarize, the FOMC is unlikely to raise rates at its December session, extending its ongoing pause. Tight monetary policy acts with a lag, suggesting that despite recent economic growth, the economy is likely still at risk of feeling its full impact. Until the fight against inflation has been convincingly won, Fed policy and broader financial conditions are likely to remain on a restrictive footing. Interest rates have risen to the point that there is now a credible cost of capital in the U.S. On the whole, increasing debt services costs are likely to eat into profit margins for businesses and disposable income for consumers, not immediately but gradually and the longer that financial conditions stay tight, the higher the odds that the broader economy faces slow growth or tips into recession.

And with that, thank you for listening! And please don’t hesitate to reach out with any questions.