Are traders relying too much on history in bets on early rate cut?

In the face of continued warnings from the Federal Reserve, traders betting on a March interest-rate cut may be relying too heavily on history, according to some strategists.

On average, the Fed has tended to ease about six months after its final rate hike, according to data compiled by Bloomberg going back to 1980. With officials expected to stand pat in January, extending a hold since July, the current pause is set to be longer than the previous episodes. 

This dynamic, along with a sustained slowdown in inflation, may be spurring traders to be too aggressive in their rate-cut positioning, according to Societe Generale. That warning rang true on Tuesday as Treasuries suffered their biggest one-day drop in two months after Fed Governor Christopher Waller called for a cautious approach toward lowering rates. 

Bond bulls are preparing to face off with the Fed again after a tumultuous year, as they bet that moderating growth and cooling price pressures will force officials to start lowering rates soon. A Bloomberg gauge of US government bonds has fallen 1% this year after a rally in late 2023, highlighting the risks that are building in the market. 

“The March timeframe seems appropriate for a policy pivot” for many, given the historical record, according to Subadra Rajappa, head of US rates strategy for Societe Generale. However, “a rate cut in March seems premature” after Fed officials highlighted the risks that inflation might rebound, she wrote in a note on Tuesday. SocGen thinks the Fed won’t cut until May.

US 10-year yields soared 12 basis points to 4.06% Tuesday after Fed’s Waller said the US central bank should take a cautious and systematic approach when it begins cutting interest rates. Yields were little changed on Wednesday.

Swaps contracts are signaling about a 70% chance the Fed will ease by a quarter point at its March meeting. That’s down from the more than 80% odds seen on Friday — when some traders even started to scoop up options hedging against a half-point reduction. But overall positioning shows the market is mostly setting aside warnings from Waller and other central bank speakers. 

SocGen’s Rajappa noted that those betting on a March move may also be looking at the decline in six-month annualized inflation to 2.6%, based on the Fed’s favored inflation gauge, the PCE core deflation reading. She also said there were concerns that the real Fed rate will become restrictive if price gains keep slowing.

Market pricing for rate cuts has gone into overdrive ever since Fed Chair Jerome Powell signaled after the December meeting that officials will ease in 2024, according to Prashant Newnaha, a rates strategist at TD Securities in Singapore. He expects a reduction in May, adding that the Fed also may be keen to go early to maintain its reputation for independence, rather than starting to ease too close to the US presidential election.

“The speed of the shift from Powell played a big role in the market’s recalibrating expectations toward a March cut,” he said. “The Fed on average switches from hikes to cuts after about eight months on hold, so on that metric we are sort of in the zone for March.”