The market is pricing in FEWER cuts than the Fed now? What does this mean going forward?

As the US started to make progress in the fight against inflation towards the end of last year, markets spent the majority of Q4 2023 rushing to price in interest rate cuts for 2024, moving from 2 to 6 cuts by the turn of the calendar year. This was in stark contrast to the Fed dot plot which called for 3 cuts in the whole of 2024. The first quarter of 2024 has been mostly a mirror image, as sticky US inflation and a strong economy have seen the market pare back rate cut expectations, with the chance of a cut at the May meeting going from 100% all the way to 5%, and June from 100% to 50%.

At the time of writing, the market has only slightly more than 2 cuts priced in for 2024 – and since the Fed dots haven’t changed, this means the market is now underpricing the Fed, a mere three months after there were 3 extra cuts priced in than the Fed for 2024. Quite a change in sentiment and move in front end interest rates. The USD index, at least partially driven by these rate moves, rallied about 4% in Q1 2024, retracing about two-thirds of the 6% selloff from Q4 2023.

The question is, where does this leave the outlook for markets for the rest of the year?

Recent data, Fedspeak, and Market Sentiment changes

US CPI reports released in January, February, and March have all come in above expectations as headline inflation remains sticky above 3% and core is running just below 4%, but it feels like the market sentiment has really started to change in April. Starting on 1 April, when the ISM Manufacturing print unexpectedly returned to expansionary territory, building through a better-than-expected ADP report on 3 April, and culminating in a very strong Nonfarm Payrolls report on 5 April, blowing estimates out of the water and showing net strong revisions to boot.

As this was happening, various Fed speakers have started to question the path of 3 interest rate cuts for 2024, although Powell himself sounds more balanced with quotes like “recent data has not materially changed the overall picture”. We are also hearing voices becoming louder from various global investors, traders, and former government officials – on 12 March, Citadel’s Ken Griffin said the Fed should move slowly in lowering interest rates to make sure they don’t have to reverse the move later. In reaction to the Nonfarm Payroll release on 5 April, former Treasury Secretary Lawrence Summers said that it appears the neutral rate is “far higher than the Fed supposes”. And in a letter to investors on 8 April, JPMorgan Chase’s Jamie Dimon said he is worried about “stickier inflation and higher rates than markets expect.”

Have things gone too far?

The market is waking up to the case for higher US yields. But now that it has overshot the Fed Dot Plot, has it gone too far?

While the case was more compelling at the beginning of the year with 6 cuts priced in for 2024, let’s pause and consider the balance of risks from here. Events that could cause US yields to reverse course and head south include:

• An acceleration of disinflation in the US - can CPI sustainably break below 3%?
• A slowdown in the economy which gives the Fed reason to potentially accelerate cuts. GDP growth and labour market seem very strong, although two consecutive retail sales misses could be early warning signs.
• Known unknowns such as the impact of rolling over commercial real estate debt.
• Unknown unknowns.

Risk factors that could underpin a move even higher in US yields include:

• The currently expected soft landing(slowing economy, no recession, interest rate cuts) turns into no landing (above trend economic growth and inflation, no interest rate cuts and potentially interest rate hikes).
• US National Debt Expansion - neither party seems to want to balance the budget in an election year, and former President Trump has pledged to cut corporate taxes.
• Geopolitics / War - the tragic situations in the Middle East and Ukraine don’t seem to be improving, with risks that US and China get more involved on opposite sides. This could lead to an initial risk off move lower in US yields, but longer-term military spending would likely push yields higher.
• R* is truly higher than the Fed thinks and Lawrence Summers turns out to be right.
• Technical factors - the US 10 year yield has broken above a previous double top and made new YTD highs above 4.35%, with a similar picture in the 2y yield.

Overall, although there are many paths the market can take and risks appear to be in better balance than they were in early January when they seemed very skewed to higher US yields, we still favour paying close attention to the risk that recent moves continue and US yields push even higher in 2024. Investors exposed to floating rate liabilities would still be well served to consider interest rate caps, or collars, as long as the yield curve remains inverted. As for FX, the reaction for the dollar could be mixed – in a scenario where inflation remains sticky and the Fed reacts with an accordingly hawkish response, it should be USD positive, but if the Fed is seen an unwilling to slow down or back away from interest rate cuts that they have forecasted, that could be a USD negative risk to monitor. The USD is overvalued by most fair value metrics and now that the cuts are priced out of the curve, is there room for the big dollar to test lower?