The three things I would tell my clients this week:
The Fed will likely hike no more than twice in the months ahead before it’s done tightening.
Logically, this means no rate cuts until the end of 2024. But markets are anticipating the first cut next May.
What market are essentially pricing in is a very severe financial accident, so big that the Fed’s new laser-focused contingency strategy won’t prevent it. While this is a non-zero risk, it is certainly not our base case scenario.
The eagle is finally about to land. In the past week, a number of key Fed officials (Daly, Goolsbee, Waller) said that they expected two more rate hikes this year. While they didn’t specifically say that the Fed would be done, lower headline inflation at 3% and the increasingly lower frequency of rate hikes suggest that the end of this hike cycle is near. The Dollar, expectedly, lost 2.5%, while gold rose nearly as much and oil gained 5%. Bond markets are still pricing in one, of course, but that’s just investors eager for the next step.
The Fed has said what it plans to do, and investors can now ignore it at their own peril.
This brings us to the real crux of the question. What will prompt the Fed to cut rates and when will that be?
Fed officials know that policy transmission may take close to a year. i.e. hiking in September, for example, means that conditions should become more tight until around September 2024. With banks eying more regulation and buttoning down the (credit) hatches, and Quantitative Tightening, conditions should continue to tighten for some time, possibly even until inflation returns near the target. This is surely part of the planning. Which means that, all other things being equal, it doesn’t make sense to cut before the end of 2024 or the beginning of 2025.
However, at the time of writing, bond markets are implying the first rate cut in May 2025 and nearly six cuts until January 2025.
Markets are not irrational. What is being priced in, then, is not a smooth return to the “neutral” rate (a rate that neither stimulates nor tightens) but that of an accident. That something will eventually break. This was our case for a long time. Then, something actually broke. US peripheral banks suffered severe losses after SVB’s collapse in March. The Fed deployed a clever strategy. It didn’t hesitate to expand its balance sheet rapidly, provide credit lines and even blanket guarantee all deposits for failing institutions. But it didn’t sway from its interest rate course. Gradually, it continued to contract its balance sheet at the same pace as before the banking crisis.
The famous central bank bazooka turned into a much more cost-effective sniper gun. And that’s the Fed’s strategy. It will counter any crisis not with massive money printing but with very fast and effective targeted actions.
What this means for interest rates is that it will not just take something to “break” for the Fed to pivot earlier than it has to. The financial accident will need to be so severe that the Fed’s sniper gun will fail. This certainly reduces the range of possible negative outcomes which would lead to faster interest rate cuts.
The base case scenario (and by far the larger probability) is a couple of more rate hikes and then cuts near the end of next year or the beginning of 2025. We can always speculate of course. But that depends on individual investment mandates and portfolio risk tolerance.