Bond traders pull back Fed rate-cut expectations

Bond traders no longer expect the Federal Reserve to lower interest rates by more than 75 basis points this year, bringing their view in line with what Fed policymakers have indicated is the likeliest outcome.

Swap contracts that predict decisions by the US central bank repriced to higher rate levels, with the December contract’s reaching 4.58% on Tuesday and only 75 basis points lower than the effective federal funds rate of 5.33%. The Fed’s target band for that rate has been 5.25%-5.5% since July.

Market-implied expectations for what the Fed will do have been converging toward the median of policy makers’ latest quarterly forecasts made in December. However, even that amount of interest-rate cuts is in doubt, with some investors contemplating the possibility that additional rate increases will be needed.

“The air has been taken out of the bubble of over-expectation of rate cuts,” said Tony Farren, managing director in rates sales and trading at Mischler Financial Group. “The market right now is fairly priced.”

Repricing of Fed rate cuts are in stark contrast to that of the Reserve Bank of New Zealand. Overnight-indexed swaps signaled deeper RBNZ rate reductions this year after the central bank lowered the forecast peak of the official cash rate on Wednesday amid signs of waning inflationary pressures.

'TOO BULLISH'

At the start of the year, the amount of Fed easing priced in for 2024 exceeded 150 basis points. For some, that expectation was based on the view that the US economy would enter at least a mild recession this year brought about by the Fed’s 11 rate hikes over the past two years. Since then, growth data has broadly exceeded expectations, while the downward trend of inflation has shown signs of stalling.

“My view in a word is ‘Finally!’” said Leah Traub, portfolio manager at Lord Abbett. “The market was way too bullish on the timing and amount of Fed cuts coming into the year.”

Fed policymakers have said that while they anticipate cutting rates this year, they first need to see additional evidence that inflation is on a sustainable path back toward their 2% target. The Fed’s preferred inflation gauge, the deflator for personal consumption expenditures, is slated to be released Thursday and will shed more light on price pressures after a gauge of consumer prices indicated hotter-than-expected inflation in January.

US EXCEPTIONALISM

The greenback, meanwhile, is just shy of the record high it reached during the pandemic and on pace for its best year since 2020 with support from US productivity growth and economic dynamism to a torrent of flows into American assets and homegrown technological prowess in crucial areas such as AI.

These fundamentals are seen mitigating the impact of Fed rate cuts when they do happen, underpinning the narrative of “American exceptionalism” for the foreseeable future.

The February employment report due next week is another major data point after this week’s PCE data with the potential to shape expectations for Fed rate cuts this year.

“The market has seemingly overshot its forward rates view quite a bit over the past year, so it wouldn’t totally surprise me to see the hawks take over until the data cools further,” said George Catrambone, head of fixed income at DWS Investment Management Americas.