At its December meeting, the Fed’s communications and its economic forecasts all signaled that inflation would fall toward 2% by the end of this year, meaning the central bank would be able to cut rates in 2024. Markets took that as a blessing to price in roughly seven quarter-point rate cuts, predicting the fed funds rate would fall as low as roughly 3.6% by the end of this year and 3% by 2025. See the yellow and green lines in the chart. Any forecast for inflation falling steadily toward 2% assumes that goods prices will keep sliding and that services inflation will ease materially from elevated levels. Those outcomes are highly uncertain, we believe. Instead, both goods and services inflation have been hotter than expected – a reality check for the Fed and markets alike. Market pricing of where rates will be by the end of this year and next has jumped in response to such sticky inflation.
On our part, we had expected goods deflation to pull inflation briefly toward 2%, before stubborn services inflation moved it back further above target in 2025. Our view on inflation’s destination likely holds. But the ramp-up in goods prices suggests it will be difficult to achieve even a near-term dip. The Fed is now accepting rates need to stay high for longer given sticky inflation. It also pushed back against hikes. Yet greater macro volatility makes it harder for both markets and policymakers to predict what’s ahead. That’s why we rely on new data, instead of Fed policy signals, to shape our view of the likely policy path.
Earnings keeping stocks afloat
Higher interest rates usually hurt U.S. stock valuations. Instead, strong Q1 earnings have supported stocks even as high rates and lofty expectations raise the bar for what can keep markets sanguine. Some 77% of S&P 500 firms reporting have beat the consensus, LSEG data show. Tech stocks and artificial intelligence beneficiaries have kept up their robust growth, while other sectors also see recoveries. Given volatile data and policy uncertainty, we think long-term U.S. Treasury yields can swing in either direction for now and stay neutral on a six- to 12-month tactical horizon. In the longer run, we think long-term yields will climb as investors demand more term premium, or compensation for the risk of holding bonds. With the U.S. Treasury boosting borrowing, we see rising debt leading to term premium’s return.
High-for-longer U.S. interest rates have implications globally, like in Japan, where the yen has slid to 34-year lows against the dollar. Suspected efforts by Japanese authorities to buy dollars may slow the slide, but the divergence between Bank of Japan and Fed policy is the source of yen weakness. Yet the European Central Bank may be able to cut rates even if the Fed keeps policy tight for longer. Europe’s inflation is cooling further toward 2% and economic activity has been weak since 2022, even with a surprise bump in Q1 GDP. The muted growth and weak earnings backdrop keeps us underweight European stocks.
Our bottom line
We see interest rates staying high for longer and keep eyeing incoming data. We remain tactically overweight U.S. stocks due to support from earnings and neutral long-term bonds given ongoing yield volatility. Professional investors can visit our Capital market assumptions page to learn more about our long-run view on developed market long-term bonds.
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