Investors are predicting the Federal Reserve will cut interest rates when faced with a slowing economy next year, and are betting the Federal Reserve is much closer to the end of its historic tightening campaign than it has signaled.
Traders in the US Treasury market are betting the Fed will be forced to cut interest rates twice in the fourth quarter of 2023. This comes despite protests this week from Chairman Jay Powell and other senior officials that the central bank will not change course on its plans to keep borrowing costs high even as it slows the pace of its rate hikes.
Treasury futures markets are suggesting that the Fed’s interest rate will peak at 4.9 percent in May, before falling back to 4.4 percent by the end of 2023. That means a reduction of about 0.5 percentage points.
Bets on next year’s rate cuts accelerated after Powell laid the groundwork on Wednesday for the Fed to end its string of 0.75 percentage point rate hikes and downgrade to a half-point hike at its December meeting. Investors also overlooked a stronger-than-expected November jobs report, released on Friday, which indicated little respite from inflation.
“I think it’s safe to say that the committee doesn’t expect any rate cuts next year. So how do we explain the difference between this outlook and what we expect?” said Matt Raskin, head of US interest rate research at Deutsche Bank, which has forecast the Fed will be forced to cut rates by 0 in December 2023. down 5 percentage points.
“I think it boils down to market participants expecting a recession next year while the committee still has a soft landing in its forecasts.”
Raskin cited yield curve inversion, a widely used predictor of a recession, among other signals.
This view fits the traditional pattern of rate-hike cycles: in every cycle since 1980 except 2004-2006, the Fed has cut within six months of peaking.
“They usually over-tighten until something breaks. That’s likely to be the case again this cycle, so we wouldn’t dismiss an optimization later next year,” said Margaret Kerins, global head of fixed income strategy at BMO Capital Markets.
That contradicts what officials have said. Powell said Wednesday that the central bank doesn’t expect a policy reversal anytime soon.
“My colleagues and I don’t want to overtighten. We don’t want to cut rates any time soon, so we’re slowing them down,” the chairman told an audience at the Brookings Institution, while reaffirming the central bank’s commitment to bring inflation back to its long-term target of 2 percent.
“Markets are trying to get their pie and eat it, too, hearing Powell say he doesn’t want to over-tighten while ignoring the second half of the sentence where he says they will keep rates in a restrictive range said Calvin Tse, head of macro policy for the Americas at BNP Paribas. “The market has taken that too far.”
Investors also warned that the market shift happened quickly and could easily be reversed.
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“The market is trading on what they last heard from the Fed and what they expect from the next CPI print,” said Matthew Scott, AllianceBernstein’s head of global rates trading. “I don’t think anyone in the market actually has a high level of belief about where the Fed will be at the end of next year.”
Economists polled by Bloomberg are forecasting that consumer prices will have risen by just 0.3 percent in November, for an annual pace of 7.3 percent, the slowest rate since December 2021.
Also earlier this week, John Williams, New York Fed President and one of Powell’s closest colleagues, said he expects the central bank to keep interest rates at levels that will stall the economy at least until late next year, when inflation picks up in between mitigate 3 percent and 3.5 percent.
“I see a point, probably in 2024, where we’re going to start cutting nominal interest rates because inflation is coming down,” he said Monday.
For Steven Abrahams, Head of Strategy at Amherst Pierpont, the recent swings in market prices have come as a “déjà vu”.
“The market has been betting all year on the Fed keeping rates high into 2023. And the market has always been wrong,” he said.