Is This Goodbye to Rate Hikes?

The Federal Reserve's Open Market Committee held its final meeting of 2023 on December 12th and 13th. As at their previous two meetings (in September and October/November), the Fed held rates steady, with the overnight rate remaining in the 5.25-5.50% range.

More importantly for investors, Chairman Powell, for the first time, discussed the possibility of lowering interest rates in 2024 to avoid harming the economy. This was a substantial change from the Fed's previous stance, which was effectively "it's too soon to talk about lowering rates." The shift in tone and message immediately drove markets higher and long-term yields lower.

While we are hesitant to deal in absolutes, it appears the current Fed rate hiking cycle has ended. Inflation continues to trend downward, and barring an unexpected reversal, we expect that to persist (although not necessarily in a straight line). The most recent report in December showed year-over-year inflation of 3.1%, a far cry from the 9.1% peak in July 2022.

While the message has changed, it seems like the Fed wants to ensure the inflation dragon is truly slain before they consent to lower rates. Cutting rates before inflation was tamed was the Fed's big mistake in the 1970s, and it eventually led to the sky-high interest rates of the early 1980s (raise your hand if your first mortgage had an interest rate north of 15%!). Expectations of three rate cuts in 2024 may prove overly optimistic if we see any resurgence of inflation.

Even if the Fed holds rates steady for longer, we could still see volatility in the bond market. Markets are forward-looking, and any change in outlook in the future can have a profound impact immediately.

For example, in the last three and a half months, we have seen dramatic moves on the long end of the yield curve. The 10-year treasury yield went roundtrip from 4% to 5% and back to 4%, all while the Fed stood pat. If those moves do not sound like much, consider that the iShares 20+ Year Treasury Bond ETF fell by nearly 14% due to that rise in rates before recovering that entire loss as rates fell.

We may be done with the current rate hike cycle, but there are still risks out there, which is why maintaining a properly diversified portfolio – even in fixed income — is key to investment success.

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