This is the 'Pain Trade' of 2024 That Depends on How Fast the Fed Cuts Rates

As 2024 commenced, the stock market rode the wave of an expansive "everything rally" driven by high expectations of imminent interest rate cuts by the Federal Reserve, all while endeavoring to sidestep an impending recession.

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While investors may accurately gauge the potential impact of anticipated Federal Reserve rate cuts, the timing of such maneuvers carries substantial risks, caution strategists Skylar Montgomery Koning and Andrea Cicione from GlobalData TS Lombard.

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In a client note on Wednesday, the GlobalData TS Lombard team contended that the market, being an amalgamation of diverse perspectives, currently seems to be factoring in a soft landing with approximately 140 basis points of rate cuts anticipated in 2024.

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The strategists argued that the roughly 200 basis points of rate cuts already priced in for the entire easing cycle might be deemed "too minimal than too aggressive," particularly if the economy experiences a severe downturn.

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However, the primary concern, according to the team, revolves around the optimistic market movements in anticipation of a series of relatively early rate cuts this year. They emphasized that, as observed at the outset of 2024, the unexpected scenario might unfold where the anticipated cuts are not reflected in market prices, potentially reversing the fourth-quarter 2023 trends of a weaker dollar, stronger fixed income, and robust equities.

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The Dow Jones Industrial Average experienced a robust rally in the fourth quarter, achieving a succession of record closes leading into the new year. Similarly, the S&P 500 index concluded Wednesday on the cusp of its first record close in two years, as per Dow Jones Market Data.

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In the realm of fixed income, the 10-year Treasury yield eased back to around 4% in the new year after reaching a 16-year high of 5% in October. The sudden prospect of elevated borrowing costs for a substantial portion of the U.S. economy triggered a downturn in stocks and momentarily erased earlier gains in the year for major U.S. bond benchmarks.

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The closely monitored Bloomberg U.S. Aggregate index showed a 2.41% increase on a one-year return basis, mirroring the performance of the iShares Core U.S. Aggregate Bond ETF. However, the strategists highlighted the potential for a further sell-off if there is a reassessment of Fed dovishness.

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In the currency domain, the ICE U.S. dollar index, measuring the greenback against a basket of rival currencies, recorded a 3.5% decline over the past three months. Despite achieving its best first four days in a new year in nearly a decade, the dollar, which soared to its highest levels in two decades in 2022, could weaken further if the Federal Reserve adopts a more dovish stance.

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Koning and Cicione noted a consensus in the market that the dollar will likely weaken in 2024 due to significant Fed cuts, and although their forecast suggests modest upside for the dollar, they acknowledged the potential ramifications. A weaker dollar may benefit major U.S. companies dependent on overseas sales, helping counterbalance heightened borrowing costs. However, Fed rate cuts might also diminish the attractiveness of assets tied to the dollar for investors seeking yield.