As the holiday season rapidly approaches, investors have added “peak interest rates” to their collective wish lists (in addition to the perennial appeal for a Santa Claus rally). While we won’t know if major central banks including the US Federal Reserve are truly done hiking rates by the end of December, we should have a clearer indication of what’s to come. 

There are a number of factors that bode well for peak rates coming to fruition. While still above target in most countries, inflationary pressure has cooled significantly. Despite economic resilience thus far in the US, growth in other countries and regions has sputtered somewhat as the impact of higher interest rates has been felt more acutely and less aggressive fiscal spending has not provided as potent an offset. Oil prices have fallen sharply in recent weeks, shaking off geopolitical concerns and self-imposed OPEC production cuts. In the US, the Federal Reserve is likely to prefer a hands-off approach with a presidential election slated for early-November 2024. While central bank inaction would likely mark the end of this rate hiking cycle, investors have an even more sanguine view. Per the chart below, derivatives markets currently expect 74 basis points of US rate cuts by the end of next year.

Are investors getting ahead of themselves?  We believe it is likely so. After all, we have been in the higher-for-longer nominal growth and inflation camp for some time now; arguing that a smooth retreat to 2% target inflation rates in most countries will prove to be elusive. Upwards pressure on wages is becoming entrenched across numerous nations and industries, with news of unions scoring significant collective bargaining victories becoming commonplace. In the US, households are still sitting on excess cash distributed during COVID lockdowns and the multiplier effect of expansionary fiscal policy continues to reverberate throughout the economy. Even China is showing signs of stabilization and a preliminary upturn in domestic activity, after the recovery out of lockdowns was short-circuited by property market stress and badly damaged consumer and business confidence. If the world’s second largest economy were able to regain its footing, this would provide a pro-cyclical boost to global growth. 

If we are correct that price pressures remain elevated (but do not accelerate meaningfully from current levels), it becomes imperative to gauge central banks’ respective tolerance for above target inflation rates. One argument posits that a period of overshooting inflation is acceptable, considering that inflation indices undershot target levels for much of the past decade. But there is a delicate balance. While central banks do not want “hard landings”, they must also retain credibility (some would argue that ship has sailed a long time ago!) and prevent inflation expectations from becoming unhinged. Perhaps Fed Chairman Jerome Powell swearing on a hot mic is emblematic of the pressure they’re under!

How should investors approach this? Whether rates move slightly higher, hold steady or fall, the key takeaway is that the rate hiking cycle in most major economies is either over or very near to it. Historically, both stocks and bonds have performed well in the years following terminal rate hikes. Additionally, there is an abundance of “dry powder” waiting on the sidelines, as approximately $USD 1 trillion poured into money market funds this year. While jittery investors will continue to scrutinize each CPI print and economic release, the outlook for long-term returns looks promising.