Twenty months after the Federal Reserve launched its historic campaign against inflation.
Interest rate futures last week indicated about a 60 percent chance the Fed will cut rates by a quarter percentage point by its May 2024 meeting, up from 29 percent at the end of October, according to CME Group data. The same data points to four cuts by the end of the year.
Bond market
One place where rate cut bets are emerging is in the bond market, where long-dated bond yields have fallen lower than short-dated yields. Treasury bond yields largely reflect expectations of what short-term rates set by the Fed will be on average over the life of the bond. As a result, such a move is usually seen as a warning of an impending recession, with investors betting that the Fed will have to cut rates to stimulate growth. This month's rebound in equities signals that many investors expect a more favorable outcome.
V there are two possible economic scenarios at play
Yet there is evidence that traders are betting on both economic scenarios. Investors welcomed this year's inflation reports, which showed a marked slowdown in price growth. However, there have also been a number of more worrying data releases, including weaker-than-expected purchasing managers' surveys and a rise in the unemployment rate. Waldner chief strategist at Invesco is among those who believe the threat of a recession has grown.
Investors warn
It is still possible that the Fed will not cut rates in 2024, which could raise bond yields again. The U.S. economy has proven resilient over the past few years, and the Fed has repeatedly raised rates higher than investors expected.
Even if inflation continues to ease, the Fed is less likely to cut rates the better the economy performs, said Thanos Bardas, global co-head of "fixed income" investment grade at Neuberger Berman. There are signs that consumers and businesses are "adjusting to a higher interest rate regime," he said.
The stock market's recent surge marks a shift from the previous three months, when long-term yields shot higher, bets on rate cuts eased and stocks in general fell, while data showed a jump in economic growth.
Lower incentive to move money into bonds
Investors argue that there are reasons why stocks can prosper when growth slows and even when the likelihood of a modest decline increases.
All else being equal, lower long-term Treasury yields could boost stocks by reducing investors' incentive to move their money into bonds. Investors were also concerned that a 10-year Treasury yield approaching 5% could trigger a recession by raising borrowing costs for businesses and consumers, although those concerns have not been reflected in bond yields.
Adding to these concerns, many worried that yields were being driven higher by the increase in new government bonds needed to finance the growing federal budget deficit, not just by a strong economy and bets on higher rates.
Expectations of a rate cut even without a recession
This month's bond recovery, which pulled the 10-year yield below 4.5%, began on Nov. 1, when the Treasury increased the volume of auction sales of longer-term bonds by less than most investors expected. This supported the case that yields had risen more than was justified by economic fundamentals, so their decline was particularly welcome. Fed officials have consistently said they are not close to discussing a rate cut .
However, they also indicated that they expect to cut rates even without a recession, once they are convinced that inflation will reach their target. In their last forecast in September, they expected rates to end next year half a percentage point lower than they were at the start of the year, or a quarter percentage point lower than they are now.
"At some point in time, and I'm not saying when, the time will come that it's appropriate to cut," Fed Chairman Jerome Powell said in September.
There is a 25% to 33% chance of a recession
Investors' new position on rates reflects factors other than their baseline forecasts. Many think the Fed is likely to cut rates by less than 1 percentage point next year.
In past recessions, the Fed has typically cut rates by about 3 to 4 percentage points over the course of a year, said Sonu Varghese, global macro strategist at Carson Group, a financial advisory firm. As a result, bets for a 1 percentage point Fed rate cut could be interpreted to mean investors believe there is a 25% to 33% chance of a recession in 2024.
However, taking into account bets for a more modest insurance cut, the perceived chance of a recession should be considered lower, perhaps around 20%, Varghese said.