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Investors are further reducing their bets on interest rate cuts by the US Federal Reserve this year, as strong economic data boosts conviction that the central bank will need to keep borrowing costs higher to cool inflation.
Markets are pricing in two quarter-point rate cuts by the Fed in 2024 and only a 50 per cent likelihood of a third, in a drastic reversal from the start of the year when between six and seven cuts were expected.
“We’re having a number of clients ask us, ‘why is the Fed going to cut rates at all?’ That’s really picked up over the last month or so,” said Evan Brown, portfolio manager and head of multi-asset strategy at UBS Asset Management. “With the economy this strong, policy isn’t as restrictive as the Fed thinks it is.”
Blockbuster jobs data on Friday added to the growing belief that the Fed may wait longer to be sure that inflation is nearing its 2 per cent target before cutting.
Since December the Fed has been signalling that it expects to cut its key interest rate by the equivalent of three quarter-point cuts this year, from the current range of 5.25 to 5.5 per cent.
Speaking after Friday’s figures, Dallas Fed president Lorie Logan said it was “much too soon” to think about cutting rates, while Fed governor Michelle Bowman said progress on reducing inflation “has stalled of late”.
On Friday, bond fund giant Pimco cut its forecast to two cuts this year, from three previously.
“The vast majority of people I speak to don’t think inflation will come back to 2 per cent sustainably,” said Jon Day, a portfolio manager at Newton Investment Management. “We think central banks are being too dovish.”
US Treasuries continued to sell off on Monday, pushing the interest rate sensitive two-year Treasury yield up 0.05 percentage points to 4.79 per cent, its highest level since November. Benchmark 10-year Treasury yields rose 0.08 percentage points to 4.45 per cent.
“Ten-year yields are drifting higher. I think they’ll retest 5 per cent over the course of the year,” said Lara Rhame, US economist at FS Investments, who has suggested the Fed will make fewer cuts than it had signalled, or not cut at all.
“I don’t think we’ll see a programme of rate cuts — say, once a quarter — but a more surgical, nip-and-tuck approach,” she added.
The shift in expectations could make it harder for other central banks to deliver multiple rate cuts this year without weakening their currencies against the dollar.
Investors also say the surge in yields could derail US stocks. The S&P 500 index of blue-chip companies is up more than 9 per cent since the start of the year.
Equity investors have largely shrugged off the shift in rate expectations, with strong economic data helping allay fears that rates staying near current levels for longer would weigh on growth. On Friday the S&P gained 1.1 per cent following the jobs figures, having fallen earlier in the week.
“If the recent trend of higher energy and commodity prices continues, then it has the potential to cause a rerun of the 2022 financial market environment, which was a grim time for bonds and risk assets alike,” said Mike Riddell, a bond fund portfolio manager at Allianz Global Investors.
Investors could get more visibility on the outlook for interest rates on Wednesday when the US publishes inflation data for March. Economists polled by Reuters expect the headline annual rate to rise to 3.4 per cent. Readings for January and February have already come in above analysts’ forecasts.
A closely watched gauge of long-term US inflation expectations — the so-called five-year, five-year forward break-even rate — has nudged up to 2.26 per cent, from 2.15 per cent at the start of the year, boosted by a recent surge in oil prices. Brent crude, the international benchmark, is trading around $90 per barrel, up from $87 at the start of the month.
Some Fed officials have suggested that the latest rise in inflation may not last. Chair Jay Powell said last week that “it is too soon to say whether the recent readings represent more than just a bump”.
UBS’s base case is still for two cuts this year, because of Powell’s comments.
“Powell has been really consistent that growth and a good labour market is not a reason to refrain from cutting rates if inflation comes down. So as long as he’s communicating that kind of a reaction, then we still need to keep rate cuts in our forecast,” Brown said.
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