We expect the Fed to surprise the market with "hawkish” patience that should drive a modest bear steepening and unwind the recent factor rotation (RTY vs. SPX.). While a ramp in buy backs after earnings, this and next week, should support megacaps, we see more risk to the downside in small and midcap companies.
Near-term Setup
The SOFR curve has bull flattened over the past month as the markets have rushed to price in a rate cutting cycle:
Interest rate probabilities implied by Fed Funds Futures and OIS both show the market pricing in 2.5+ cuts by December 2024:
The Russell 2000 (small caps) has outperformed large caps since mid-July:
The Fed (just last month), in their Summary of Economic Projections, the median dot pointed to 2 cuts in 2024 and 4 in 2025:
Resilient GDP and spending data does not support a shift in the Feds stance:
Because of both stated Fed guidance and supporting data, the Fed will be patient and communicate that (1) interest rates are restrictive, (2) that the Fed is attuned to changes in the labor force, (3) that strong economic data and inflation still above target means the job is not “done”, and (4) that the Fed will be patient in keeping rates higher for longer. In this dynamic, we expect the Fed will push back against market pricing nearly 3 cuts in 2024 and 6 in 2025 vs. the Fed’s guidance of 2 in 2024 and 4 in 2025.
Cross-Asset Implications
Near-term, we expect the yield curve to bear steepen, with the 2-year and the 10-year crossing back up above 4.5%. In equities, an unwind in the recent factor rotation should drive mega caps neutral-to-marginally higher, while small caps will underperform. We are not calling for a major crash from here — the market is already down nearly 10% from its peak in mid-July.
In our strategies we have raised cash, trimmed risk, and reduced net exposure into the second half of July. We anticipate adding back by mid-August.
If you have any questions, concerns, or comments please feel free to reach out to me directly.
Sincerely,
Muhammad Wahdy
Portfolio Manager
Wahdy Capital
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