Bond investors and interest rate traders are increasingly betting that interest rate cuts will begin by the summer, calling into question policymakers’ mantra of high borrowing costs for the foreseeable future.
Markets are already betting that the Federal Reserve will cut interest rates for the first time in June, and by the end of 2024 will have made cuts of almost 100 basis points. A similar amount of reductions is estimated by the European Central Bank, and they may start as early as April. And the UK saw the Bank of England cut its benchmark interest rate by nearly 70 basis points.
That could prove a problem for central bankers, who recognize the extent to which expectations of keeping policy tight have pushed up bond yields, helping to cool the economy.
“Officials will want to resist this for as long as possible to avoid easing financial conditions,” said Henry Cook, senior economist at MUFG. If the data continues to deteriorate in the coming months – as Cook expects – the central bankers’ stance “will become increasingly difficult to maintain”, he said.
Bets on interest rate cuts are rising. Since mid-October, money markets have raised bets on policy easing
The pricing underlines market skepticism that has settled in beyond 2021, when central banks have insisted that inflation will prove transitory. For rate-setters, the fall in bond yields threatens to ease financial conditions whether officials cut or not, undermining the impact of the hikes they’ve already made.
ECB Executive Board member Christine Lagarde hit back, warning that any discussion of when to cut interest rates was “totally premature”.
“The challenge is how to prevent overexcitement in the market,” said Sebastian Vismara, senior economist at BNY Mellon Investment Management. “As long as there is no real risk of a rate hike, I think the market will continue to have that tendency to value rate cuts.”
Traders scrambled on Friday to push forward expectations for the first US interest rate cut since July to June after data showed weaker-than-expected payrolls and rising unemployment.
“Self-destructive”
There is a danger that aggressive positioning will prove detrimental to them. This wouldn’t be the first time they’ve been on the wrong side of a deal. Time and time again during this cycle, the market either rushed and announced the end of interest rate hikes too early — or set tightening prices that quickly proved excessive.
The yield on US 10-year yields fell from 5% to 4.50% in less than two weeks on expectations that rate hikes were over. Just as Fed Chairman Jerome Powell acknowledged last week that rising bond yields have helped policymakers, central bankers are on alert for signs that financial conditions may be easing too quickly.
Such an outcome “could be self-defeating, and central banks may have to step in again and try to turn it around,” Wismara said.
In the UK, where inflation is three times the 2% target, Bank of England governor Andrew Bailey has sought to blunt market bets directly. On Thursday, at the Bank of England’s press conference after the interest rate decision, he reiterated that it was too early to think about easing policy.
“Markets do not believe the Bank of England will resist cutting interest rates if activity contracts or employment worsens, regardless of the inflationary backdrop,” said Axel Bote, head of market strategy at Ostrum Asset Management in Paris.
Too rushed?
Some strategists argued that the market assessment was wrong and investors were quick to turn their attention to a rate cut.
Mark Dowding, chief investment officer at BlueBay Asset Management, doubts any major central banks will cut for at least another nine months. Inflation is still above target and so far there are few signs of a serious weakening of the US economy, he said.
According to Adam Kurpil and his colleagues at Societe Generale SA, those positioning themselves for 100 basis point cuts by the ECB next year will be disappointed.
“The latest FOMC meeting has given markets a chance to re-sign a rate-cutting cycle and risk assets to rally,” they wrote. “This may prove to be more complicated than the markets want.”
At the same time, the view is emerging that policy is already too restrictive, suggesting that market pressures will remain strong.
In Canada, the central bank’s decision to leave open the possibility of another hike was condemned by the former head of Pimco’s Canadian portfolio management division, who said policymakers should now be talking about cuts.
Meanwhile, David Zahn, head of European fixed income at Franklin Templeton, said bets on cuts in Europe from April may be premature, but further into the future the ECB will need to loosen more than estimated in moment to support the economy.
“It is quite clear that they are no longer raising interest rates and now the question is when they will start lowering them,” he said. “You want to start looking at going long in portfolios to be ready for a sustained rate cut cycle in Europe.”
