The 180-degree turn in the markets is confirmed: now investors assume that the Fed will only cut interest rates twice in 2024. A milestone that culminates a paradigm shift that has been brewing in the markets in recent months, especially in the last few weeks. In January, the Bloomberg ‘swaps’ market regarding interest rates was betting on six 25-basis-point rate cuts starting in March and with clear options for a seventh move in December, despite the Fed’s ‘dot plot’ saying there would be three. A worsening economy and declining inflation were the keys that led investors to believe that Powell would have to move earlier than expected, breaking his own forecasts. Now, they believe that the institution will once again not adhere to its ‘dot plot’, but this time for the opposite reason.
The probability that the Fed would keep interest rates unchanged for June has gone from 26.6% a month ago. This Monday, it is trading close to 50% and has even exceeded it. What has changed since then is that inflation has not shown signs of receding while the US economy and labor market continue to show constant strength, providing the Federal Reserve with ammunition to keep ‘the price of money’ high for longer to ensure that it meets price stability. The latest data that reinforced this trend was the monthly employment figures released this Friday, which surprised positively with the creation of 300,000 non-farm jobs and unemployment falling to 3.8%.
After these figures were released, the possibility of only two rate cuts approached 50%, but it was still not the most likely option. Since then, various statements from Federal Reserve members over the weekend have continued to fuel the theory of fewer rate cuts. Following this, different Federal Reserve members spoke, once again reinforcing the idea that it is better to wait. An example of this was the statement from Lorie Logan, president of the Dallas Federal Reserve, who explained that “it is too early for this, it is not time to cut rates yet.”
Some members have gone further by specifically stating that rates would not be touched this year. This was the case with the president of the Minneapolis Fed, Neel Kashkari, who argued last Thursday that “if employment is increasing, inflation is on target, and businesses are doing well, why cut rates?” Meanwhile, Michelle Bowman, a member of the central bank, even left the door open for a rate hike given the positive macroeconomic data.
In this context, the inflation data to be published this Wednesday in the United States, which will show the first reading of the CPI evolution in the country during the month of March, is key to determining where interest rate cut expectations will move in the United States, and also has the potential to impact the bond market in the coming days. In fact, the week has started with aggressive selling of government bonds, both in Europe and the United States. “Following the surprising payroll data from last Friday, and some aggressive comments by Fed members over the weekend, the inflation data on Wednesday in the United States is crucial,” explains Rainer Guntermann, a strategist at Commerzbank.
The latest employment data has reignited the sell-off process in fixed income that started at the beginning of the year. If bonds closed 2023 with a price rally that brought their yield down from 5% to 3.8%, the shift in growth and inflation prospects has generated the opposite movement in the first months of 2024. The U.S. bond has just touched 4.44% for the first time this year, after a Monday where sales increased its yield by 4.4 basis points, already leaving investors with losses of 4.5% since the first day of January, again, a very negative year for investors in U.S. debt.
European bonds also started Monday with widespread selling, and the 10-year German bond saw its yield rise by 4.6 basis points, to 2.44%. In the case of the Spanish bond, it increased by 3.3 basis points on Monday to 3.26%, the highest level seen in the last month.
Strong Economy and Inflation
Aside from the recent employment data, inflation in the U.S. unexpectedly rose in February to 3.2%, with the core rate dropping only one-tenth to 3.8%. Since inflation hit bottom in November, specifically at 3.1%, it has remained stagnant at these levels, far from following the trajectory that seemed to be set from the end of summer and continuing to decline towards price stability. Additionally, the Federal Reserve itself believes that the core inflation rate will reach 2.6% in December and will not return to its target until 2026.
On the other hand, GDP has shown strong growth with a 3.3% increase in the last recorded quarter (the final quarter of 2023). S&P Global expects the U.S. economy to continue growing, and in fact, they raised their real GDP forecasts in their latest report from 1.5% to 2.4%. The Federal Reserve, on the other hand, also revised its economic growth forecasts with an increase from 1.4% to 2.1% at its March meeting.
Market Calendar
The calendar, in any case, is one of the elements that raises the most doubts, particularly due to the relationship between the Fed and the ECB cycles. The European institution will meet this Thursday, and although no rate cuts are expected until June, all assume that Lagarde and the institution’s statement will hint at a first cut for the sixth month of the year. In the case of the Fed, the path is filled with uncertainty. To begin with, the inflation data this Wednesday will be key to determine their next moves, but the institution will not meet until May 1, where no type of movement is expected.
Right now, there is maximum uncertainty about the first rate cut because the possibility of it happening in June, the month where it seemed clear that the new cycle would begin, is fading. Currently, the option of a cut in that month is a coin toss with almost a 50% probability, at several points, the most likely option was a cut in July, creating a mismatch between the two central banks. The first cut would come on June 12th or at the July 31st meeting, and the second, in November.
The Federal Reserve would not adjust interest rates for the rest of the year, confirming the ‘mismatch’ with the ECB. In the case of the European institution, it would start its first rate cut in June, followed by two more in September and October, according to Bloomberg’s swaps market. In this case, there has also been a reduction in expectations, as it was expected, until this Monday, for a further cut in December.
Why Adjust Rates?
Now analysts believe that these moves could be, even, too optimistic. In statements to CNBC, George Lagarias, chief economist at Marzars, argues that “the Federal Reserve has been punishing itself since 2021 when they mistakenly talked about transitory inflation.” Lagarias argues that “they feel they cannot make the same mistake again and it is clear that they prefer to err on the side of caution (keeping rates high for longer). You don’t want to be the Federal Reserve that cut rates too early, letting inflation continue to exceed expectations.”
Experts like Ed Yardeni, one of Wall Street’s leading gurus and president of Yardeni Research, joined this position, stating that “investors are beginning to dismiss the possibility of a rate cut throughout the year.” Bank of America does not provide a definitive conclusion but believes that the June meeting will be crucial because “if the Federal Reserve does not lower rates then, it will be very difficult to justify a later cut in 2024.” For the American firm, “the effects of PCE will be unfavorable for six of the last seven months of the year.” Only a worse economic situation could push the central bank to cut rates, an option that does not seem to be on the table for now.
