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Sorry, how many rate cuts did you say are priced for next year?

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It seems like markets are shrugging off Fed Chair Jay Powell’s warning that it’s “premature” to start talking about rate cuts.

Interest-rate futures are now pricing roughly 1.25 percentage points of rate cuts next year, CME data show. That’s the equivalent of five 25-basis point rate cuts, and could mean one cut at more than half of 2024’s eight meetings, or fewer sharper cuts.

Markets have been pricing in a dovish outlook for weeks, to be sure. And the main change since Powell’s comments has been mildly hawkish. The fed funds futures market is leaning slightly more towards rates at 4 to 4.25 per cent at the end of next year — before Friday, there was a higher market-implied probability of rates falling below 4 per cent next year:

Still, compared to even one week ago, there’s been a big jump in the market-implied probability of rates below 4 per cent.

Here’s what Morgan Stanley’s equity strategists have to say about the change:

From our perspective, the Fed hasn’t really changed their guidance all that much over this period but the bond market’s view is what matters. The net effect of this perceived pivot (both ways) hurt bonds and stocks between July and October and has helped considerably since then. With 130bps of cuts now priced into the Fed Funds futures market through year end 2024, investors have set a high bar for cuts to be delivered.

When it comes to the question of pace, Deutsche Bank’s call is for the Fed to cut rates 175bp in just the second half of the year. But the strategists guess that the central bank could take a more proactive approach if inflation and the labour market both slow further.

The strategists add another interesting nuance to their call, and it has to do with policy “inertia”. If central bankers use “inertial rules” for setting rates, they consider the recent path and level of interest rates in policy decisions. Under “non-inertial rules”, ignore history and only look at the recommended level of rates given current economic and financial conditions. If the US economy does fall into a recession, DB says, the central bank is likely to shift to a “non-inertial” approach and cut rates quickly:

. . . the Fed is likely to begin to cut in June and reduce rates by a total of 175bps through year-end — a more aggressive path than consensus and market pricing. The case for cuts by mid-year is pretty clear on our forecast. At that time, core PCE inflation will have convincingly fallen below 3% in year-over-year terms — shorter-term measures will be even lower — and the unemployment rate will have risen to near 4.5%. Indeed, a range of projections from canonical non-inertial policy rules [such as the classic Taylor Rule] — which to us are more relevant than inertial rules in a mild recession world where the Fed will not be slow to act — would suggest the Fed should cut rates earlier and more aggressively than our forecast anticipates

Economic data does indeed show that inflation is slowing worldwide. Still, EU inflation is closer to target levels than US inflation, and it’s notable that this unusually transparent Fed leadership remains so far away from the market in its communications.


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