Equities Don't Need Cuts to Rally

Equities rallied in March 2023 as the US Banking Crisis indicated that the Fed's hiking cycle may be reaching its end. When they delivered several more hikes, equities reversed their gains. However, when the Autumn brought a second round of interest rate cut bets, equities rallied once more. This time, the market pricing those cuts out did not cause equities to retrace. Instead, we have seen a strong rally into the first quarter of 2024 that has not lead to an increase in implied volatility or protective put-buying skews of the volatility surface. What is driving the rally now, and how long can it be sustained?

Macro

Equities retraced when rates priced out cuts

March 2023 marked a turning point in the Fed’s hiking cycle – or at least in how the market was reacting to it. A week before the FOMC meeting on the 19th of March, the US Banking Crisis began to unravel and SVB, Signature, and First Republic banks collapsed.

Here, the market first started to price for a cut in interest rates, rather than a continuation of the hiking cycle. This can be seen in the chart below, which shows the upper-bound of the Fed Funds target rate in blue, alongside the 3M (white), 6M (orange), and 1Y (purple) forward rate implied by Fed Funds futures markets.

Figure 1. Fed Funds Rate implied by futures at a 3M, 6M, and 1Y tenor, overlayed with the actual Fed Funds rate (upper bound) in blue. *Source: Bloomberg*

While the bank collapses themselves threatened to cause a slowdown in growth, the pivot to pricing for cuts coincided with the beginning of a strong rally in equities as markets priced in the possibility of less restrictive monetary policy. The rally was led by a small number of tech stocks, likely accelerated by the adoption of AI. This can be seen in the chart below by the strong out-performance of the NDX index over the S&P 500 in this period.

Figure 2. S&P 500 index and Nasdaq index prices from Jan 2023 to March 2024. The 2023 US Banking Crisis (March 2023) and beginning of the October rally are marked with white vertical lines. *Source: Bloomberg*

However, the rally in equities lasted until mid-July only. In those four months we saw 3 further hikes – albeit of the smaller, 25bps variety, and the strong probability of cuts that had been priced-in was reversed. The falling likelihood of a cut at the March 2024 meeting matched the retrace in the equities rally that lasted until October 2023.

Figure 3. Historical probability of a cut in the Fed funds target rate at the Federal Reserve meeting on 20th March 2024 as implied by the prices of Fed funds futures. *Source: CME FedWatch tool*

Rates priced out cuts again, but Equities continued to rally

In March 2023, the beginning and end of the rally in equities coincided with the beginning and end of themarket's pricing for cuts. The resumption of the rally in equities coincided with the resumption inmarket pricing for cuts in October, but the rally continued despite another retrace in bets for rate cuts.

Markets began to price for cuts again in the last quarter of 2023. This began following the FOMC’s decision to hold rates and allow themselves space to make their decisions “based on the totality of the incoming data” on the 20th of September. CPI reading after NFP release showed inflation continuing to cool and the labour market continuing to loosen without a marked decrease in the number of jobs added each month – all signs were dovish.

Figure 4. CPI (light blue) and NFP figures (green bars), together with the 6M Fed Funds Rate implied by futures (orange), overlaid with the actual Fed Funds Rate (upper bound, blue shaded). *Source: Bloomberg*

Equities resumed their rally soon after, at the end of October. But while sticky CPI readings in early 2024 meant that the rally in rates culminated at the end of December 2023, equities have kept on rallying – past all-time highs.

Figure 5. Spot price rallies in US equities, represented by the strong performance of the Nasdaq (blue) and S&P 500 (white, shaded) indices during 2023 and 2024. *Source: Bloomberg*

The bullishness is reflected in options markets too. The 25-Delta Put-Call skew is at its lowest levels since 2006, before the GFC. The chart below shows that 6-month puts on the S&P index are priced with a historically low premium to calls, despite trading around 5 vols higher for much of the last 18 years.

Figure 6. S&P 500 index options 25-delta put-call skew at a 3 month tenor from 2006 onwards. *Source: Bloomberg*

Their uncertainty around the best-case scenario path is low too. It’s not just low considering that we’re at the business end of a hiking cycle (where things have historically tended to blow up) – volatility is at its lowest levels in the last 4 years, since before the pandemic.

Figure 7. S&P 500 index options at-the-money implied volatility at a 3-month tenor from 2006 onwards. *Source: Bloomberg*

What is driving this rally?

Despite markets again cutting back bets on a fast and early program of cuts, equities have continued to rally since mid-Jan 2024.

Figure 8. S&&P 500 index (white, shaded), 1Y future-implied FFR (purple), and NDX (blue). *Source: Bloomberg*

There are a couple of possible drivers. First, growth in GDP in the third and fourth quarters of 2023 was incredibly strong – contributing to an overall growth rate of 2.5% for the year. That was far stronger than the 0.5% that had been projected by the Fed themselves in their March 2023 Summary of Economic Projections.

Secondly, we have seen a second-wind in the excitement around AI-driven boosts to productivity that has spanned sectors, as shown by NVDA’s (a key producer of the GPUs needed to train GPT models) astonishing 80% return since the beginning of the year. But strong out-performances in tech and telecommunications have merely accentuated a broader based rally across sectors, as shown in the chart below. Real estate is the only sub-sector in the index to report a loss YTD. Is such a rally sustainable?

Figure 9. Performance of sub-sector indices of the S&P 500, alongside SPX (white, shaded). *Source: Bloomberg*

What about last time?

We saw a similar phenomenon in 2007 – a rally in equities in 2007 while markets were reversing their expectations for cuts to the FFR. But unlike the present day rally, we cannot attribute any of that rally to surprisingly resilient growth in the economy. Instead, growth was actually reported to be slowing during the rally in equities and pricing out of cuts between March 2007 and July 2007.

We can see that highlighted by the red vertical lines in the chart below, which show the three releases for Q1 2007 GDP growth at 1.3%, 0.6%, and 0.7% respectively.

Figure 10. SPX (white), FFR upper bound (blue, shaded), 1Y implied FFR (purple), and NDX (blue). *Source: Bloomberg*

But the reason for that rally was clear. Looking at industry subsectors of the S&P 500 index, we see that it is the energy sector that drove the rally higher during this period. Oil prices (shown in a thick red line in the chart below) rose to new highs, driving earnings for energy companies and boosting equities valuations.

Figure 11. Performance of sub-sector indices, SPX (white, shaded), and oil price (red). *Source: Bloomberg*

Without the ticking time-bomb in the housing market, equities may have followed oil prices for another year longer. Indeed, the rally in the first part 2007 was not fully reversed until the Fed had cut several times after contagion had spread. The broad selloff in equities happened in mid 2008, coinciding with a massive selloff in oil prices – both of which resulting from the common factor of the broadening slowdown in economic activity.

Figure 12. SPX (white), FFR upper bound (blue, shaded), 1Y implied FFR (purple), and oil price (red) during the Fed's cutting cycle in 2007 and 2008. *Source: Bloomberg*

Barring another extraneous risk to the economy like the GFC or the pandemic, continued AI-driven strength in equities that provides support for the rest of the economy means that the Fed has little reason to cut quick and fast. Instead, we may see a slower program of cuts that is repeatedly put on hold until later in the year. That’s even more likely if inflation readings refuse to come down sustainably below the 2% target and there is no fall in employment.

However, if the strength really is driven by one sector alone, then the exceptionalism of the US economy appears slightly precarious. If the rally in equities isn’t able to broaden, or AI-driven equities valuations begin to collapse or retrace, then we could see a cycle-ending event where the economy grinds to a halt and the Fed is forced to begin cutting in earnest.

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