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The market’s stubborn hopes of a first cut to US interest rates in March were finally crushed over the past week by strong economic data and firm messaging from Jay Powell, chair of the Federal Reserve.
Beyond next month, however, traders have a different outlook for the Fed’s monetary policy than officials inside the US central bank. The divergence sets the stage for volatility and potential losses if the Fed sticks with its plans.
US interest rates have been perched at a 23-year high since the Fed undertook an aggressive campaign to rein in inflation. When and how fast it begins to lower them from their current level of 5.25 per cent to 5.5 per cent has been a fixation for investors across financial markets.
Powell reiterated on a television show over the weekend that central bankers saw three cuts as their baseline scenario this year, the same message conveyed in the Fed’s closely watched “dot plot” projections issued in December.
But since December, traders in the futures market have only slightly pulled back their expectations — pricing in five cuts over the course of the Fed’s seven remaining meetings this year, instead of a more optimistic six cuts.
And bets on cuts happening earlier have been very hard to shake. Until last week traders were putting better than even chances on a cut in March. It took a definitive statement from Powell in the press conference after the Federal Open Market Committee meeting last week — March was not the Fed’s “base case” — followed by a surprisingly strong US jobs report on Friday and his statements on the 60 Minutes news programme to bring the odds down to 20 per cent today.
“We’re slowly coming into line with the Fed,” said Sonal Desai, chief investment officer for Franklin Templeton Fixed Income. “There was a sense in December that the market could push the Fed to cut sooner. But the data hasn’t co-operated with the market. The data has not been weak enough to pressure the Fed to cut early.”
“Markets finally started listening to Powell after the jobs number on Friday,” Desai said.
Bond markets have swung dramatically in the past four trading days, recording their biggest daily moves in months, as investors have grasped that March is likely to come and go without a rate cut.
The yield on the two-year Treasury note, which moves with interest rate expectations, on Friday rose 0.16 percentage points after the payrolls report, which showed employers added 353,000 jobs in January. The yield rose again on Monday to 4.48 per cent, its highest level in a month.
More swings like that may be in store if the market is forced to adjust to the Fed’s view. After hitting a four-month low in January, the ICE BofA Move index, which maps expectations of volatility in the Treasury market, has ticked up in February as rate expectations have changed.
US stocks, meanwhile, rose to all-time highs on Friday after the strong jobs report, before dipping on Monday. But anticipation of more cuts than the Fed is expecting could also be bolstering prices.
Amanda Agati, chief investment officer at PNC Financial Services, said: “The market is craving the sugar high from additional policy stimulus, but that doesn’t mean they’ll get it. It sets the stage for a choppy first half.”
The persistent tension between what the market is pricing and what the Fed is signalling on interest rate policy has also made it more challenging for corporate borrowers to map out funding plans in advance, fuelling a wave of opportunistic borrowing.
A sharp rally across financial markets at the end of last year created a relatively benign backdrop for companies in the first few weeks of 2024, leading to record January US investment-grade bond issuance, along with significant volumes for junk-rated names.
Market participants noted companies were choosing to issue debt while the going was good — with demand high because many investors had been starved of new supply for months and had cash on the sidelines.
Torsten Sløk, chief economist at investment firm Apollo, said: “I think corporates both in investment grade and high-yield [and in] loans view this as ‘Take it while you can get it’ — and in January, it turned out to be a good idea.”
However, highlighting the increasing challenges of timing such issuance, Sløk added that “the question after the [labour market] data on Friday is whether that window is closing”.
Calvin Tse, head of Americas macro strategy at BNP Paribas, said he does not believe the current gap between the Fed officials’ and the market’s expectations of rate cuts is significant. Traders in the futures market are betting on a range of possible outcomes, while Fed officials are making more precise forecasts.
But Tse’s outlook does diverge significantly from the Fed’s. Tse believes the Fed will start reducing interest rates in May and continue to cut by 0.25 percentage points at each of the five subsequent meetings this year. That’s because he expects inflation to slow dramatically this year, and the Fed will be forced to adjust policy accordingly.
Tse said: “If the Fed doesn’t cut rates, and inflation comes down as much as we think it will, that would mean policy was becoming more restrictive. And Powell has already said that policy is sufficiently restrictive.”