Evening Brief – 02.12.24

Clear as Mud

In the spring of 2023, US Treasury yields fell significantly implying that the Federal Reserve would cut interest rates. However, as the central bank proceeded to raise interest rates, yields spiked and forced traders to quickly cover those positions.

While interest rate hikes are out of the question, the market’s recent predictions that rate cuts are imminent appear premature again. In the middle of January, the U.S. 2-year yield fell to 4.14%, signaling peak bullishness for market expectations that a March rate cut was imminent.

However, Fed officials have continued to push back on market expectations. Spectacular fourth-quarter GDP and January nonfarm payrolls data added to the perception that the economic recovery remained resilient, therefore interest rate cuts can be delayed. After a few weeks, the market is finally getting the hint and modifying expectations accordingly.

The 2-year yield versus the Fed funds rate is one of the most reliable indicators of the US Treasury market’s implied bet on the future in relation to Fed policy. The recent dramatic downmove in the ratio has created an enormous divide between the two instruments. The wide spread strongly points to a market that believes a rate cut is coming much sooner than the FOMC projects.

The disconnect between what the market is or was expecting and the Fed’s plans became important enough for Fed Chair Jerome Powell to appear on national television to explain: “We feel like we can approach the question of when to begin to reduce interest rates carefully.”

Minneapolis Federal Reserve President Neel Kashkari, who has joined a bevy of Fed officials in recent weeks, recently gave a not-so-subtle hint by writing that Fed policy is less restrictive for economic growth than it appears, allowing the central bank to be patient with interest rate cuts.

“This constellation of data suggests to me that the current stance of monetary policy… may not be as tight as we would have assumed given the low neutral rate environment that existed before the pandemic,” he noted.

It isn’t helpful that the most recent ISM Services survey data for January showed the greatest monthly increase in the prices-paid component in 12 years. While there’s reason to be wary about reading too much into one month of survey data, economists at Wells Fargo noted that, “The ISM services report is not what policymakers at the Federal Reserve wanted to see” because “it’s hardly supportive of the case for rate cuts.”

Not surprisingly, Fed funds futures now estimate the likelihood of a March rate hike at about 17%. The first FOMC meeting with a better-than-50-50 chance of a cut is now the May 1 meeting, with a current probability of approximately 66%.

The timing of intertest rate cuts remains clear as mud – again. May could mark the starting point, but the Fed, as always, is data dependent. The concern is that monetary policy may revert to the 1970s Arthur Burns (Fed Chair from 1970 to 1978) era, when inflation dropped the central bank eased off the monetary pedal, and inflation rose again.

Powell is determined not to repeat Burns’ policy mistakes, in part because the Fed is aware of the danger this time and wants to maintain recent progress in managing inflation. To that end, the market will keep a close eye on this week’s January inflation report. Meanwhile, anticipate the bond market to remain cautious unless new data provides grounds to reconsider its dovish point of view.