Financial markets are falling into line with the Federal Reserve’s outlook for US interest rates, as stubborn inflation data forces investors to relinquish their bets on extensive cuts this year.
This month traders have slashed their bets on the number of times the Fed will cut rates in 2024, from six in January to a current level of four. They have also pushed back their expectations of when those cuts will begin, from March to June.
The retreat marks a shift in the relationship between the Fed and the market, which have been pushing competing outlooks for interest rates back and forth for several months.
“The Fed and markets are in a slapping competition,” said Edward Al-Hussainy, senior analyst at Columbia Threadneedle, comparing it to Power Slap, a contest in which rivals take turns to hit each other across the face until one side submits.
“The Fed is winning the fight for now — they’re in control at the moment. They only lose if things become disorderly,” he said.
The debate over US rates, which stand at 5.25 per cent to 5.5 per cent, a more than two-decade high, was given fresh impetus in December when Fed officials on average projected three rate cuts for 2024 as slowing price growth raised hopes that inflation had been tamed.
Minutes from the Fed’s January policy meeting, published on Wednesday, reaffirmed that officials were cautious about cutting rates too quickly, describing them as “highly attentive” to inflation risks.
Investors, with memories of being wrongfooted by Fed projections in the past had bet that a sharp deceleration in inflation would allow the central bank to move faster. However, a series of strong reports, from consumer inflation data to jobs figures has strengthened the Fed’s hand, and traders are coming around to its view.
“After the December FOMC meeting, the market and the Fed’s expectations for interest rate cuts were historically out of whack,” said Meghan Swiber, a US interest rate strategist at Bank of America.
“A big driver of that gap between the market and the Fed was the market’s expectation for a very quick pace of disinflation. The recent data flow has pushed back on that,” she added.
Some have profited from the discrepancy. Rokos Capital Management, run by billionaire star trader Chris Rokos, has turned a profit of more than $1bn this year as the market came to accept the central bank’s forecasts.
Consumer price inflation has proved to be more stubborn than traders were expecting. Price growth slowed in January — to 3.1 per cent — but not as quickly as economists had forecast. The closely watched core inflation measure, which strips out volatile food and energy components, was stagnant at 3.9 per cent.
The middling inflation data comes alongside evidence that the US economy continues to boom, with employers adding nearly twice as many jobs as expected in January.
Part of the opposition to the Fed’s forecasts reflects a widely-held view among investors that the central bank is slow to act on changing economic conditions.
In December 2021, Fed officials projected on average three quarter-point rate rises in 2022, implying that rates would remain under 1 per cent. Surging inflation ripped through those forecasts, forcing the Fed to raise rates to a range of 4.25 per cent to 4.5 per cent by the end of the year.
But what was true on the way up may not hold for the ride down.
“My thought is [the Fed will] probably cut interest rates at consecutive meetings, assuming the economy is doing well,” said David Rogal, a portfolio manager on the Total Return Fund at BlackRock. “The thing the Fed doesn’t want to get into is a stop-start policy. They don’t want to risk restarting inflation, which they could do if they cut now.”
A signal from the Fed that it was ready to ease could send consumer inflation expectations higher — which might encourage companies to raise prices — and could set off a rally in stocks and bonds, making it even easier for companies to borrow money.
Moreover, the US unemployment rate remains stable, near historic lows at 3.7 per cent, and has taken pressure off the Fed to cut rates.
“Rates at this level are not restraining anything, so why are cuts necessary? You would have to convince me that 5.5 per cent is causing problems — and I don’t see that,” said Jim Bianco, head of Bianco Research.
“Unemployment is low, jobless claims are low, the US is adding jobs. Everything about this economy screams that the funds rate is not a problem where it is,” he said.
Bianco is among a few who are betting that the Fed may not even cut three times this year, forecasting between two cuts and none at all. Larry Summers, the former Treasury secretary and noted inflation hawk, told Bloomberg he saw a 15 per cent chance that the Fed might be forced to raise rates.
Despite the shifting expectations, markets remain unruffled, with the S&P 500 hitting a fresh high earlier this month.
January was a record month for US investment-grade bond sales while the “spread” or premium paid by high-quality borrowers to issue debt over the US Treasury stands at just 0.96 percentage points — the tightest level since January 2022, two months before the Fed launched its aggressive campaign of rate rises.
Even so, retreating expectations on rates could still sting for some. Commodity Futures Trading Commission data shows that asset managers had the largest-ever long position in two-year Treasury futures — a bet that prices would rise and yields would fall — in November.
Bank of America’s global fund manager survey for February still showed that investors were betting on a steeper yield curve — expecting yields on two-year yields to fall, or rise less than longer-term yields.
Higher rate expectations could make this a “pain trade”, said Swiber.
