New Year: Markets want six rate cuts. They'll be disappointed

Forward markets start 2024 pricing in six quarter-point rate cuts, the first as early as March. Wall Street is giddy at the prospect, and investors are likely to be disappointed. The gap between what markets want and what the Federal Reserve will tolerate has rarely been so wide.

How the pivot talk started

The Fed has held its policy rate at 5.25 to 5.50 per cent since July, after raising it from near zero over sixteen months. For most of the autumn officials insisted that rates would stay high for a long time. The mood changed at the December meeting, when the committee's median projection showed three quarter-point cuts over the coming year, taking the rate to about 4.6 per cent by the end of it. Jerome Powell did not push back hard at his press conference, and bond markets took that as permission to price far more.

Within days John Williams, president of the New York Fed, tried to cool the speculation, saying in effect that cuts were not yet on the table. Markets largely ignored him. The Fed's own projections of three cuts are now only half what futures imply, and the difference is concentrated in the first half of the year.

What six cuts would take

For the Fed to cut by 150 basis points in 2024, the economy would need either to slide quickly into recession or to see service-sector wage inflation fall away almost perfectly. GDP is growing faster than its potential, unemployment is below four per cent and financial conditions have loosened a great deal. Cutting hard in those circumstances would risk reviving inflation. Central bankers will move slowly, and markets will find the pace frustrating.

The loosening since October is striking. The ten-year Treasury yield touched 5 per cent in October and ended December below 4 per cent. Average thirty-year mortgage rates have fallen from close to 8 per cent to below 7 per cent, and the S&P 500 finished the year within a whisker of its record high. Much of the tightening the Fed achieved through higher long-term rates has already been undone by the market's expectation of cuts, which gives officials a reason to talk those expectations down.

The case for the market

The strongest argument for aggressive cuts comes from real interest rates. Inflation has fallen much faster than the Fed expected a year ago, and on a six-month basis core inflation has been running not far from the 2 per cent target. If the policy rate stays put while inflation keeps falling, the real rate rises, and policy becomes tighter without any decision being taken. Several officials have acknowledged that argument, and it points to cuts during the year.

A sudden weakening of the labour market would add to the case. Payroll growth has slowed, job openings have come down from their peak, and the resumption of student-loan repayments in October has squeezed younger borrowers. If unemployment rose by half a percentage point in a few months, the Fed would cut quickly and six moves could even prove too few.

Why the committee will go slower

The case against is that the Fed's dual mandate is not yet threatened on the employment side, and its credibility on inflation took a heavy blow in 2021 when it called price rises transitory. Officials will want several more months of core inflation near target before they risk cutting into a strong economy. Wage growth, though easing, is still faster than is consistent with 2 per cent inflation, given normal productivity gains. A March cut would require the committee to be confident by then, and at present it is not.

The balance sheet complicates matters further. The Fed is still running down its bond holdings by up to $95 billion a month, and cutting rates hard while that run-off continues would pull policy in two directions at once. The committee has given no sign yet of when the run-off will slow, which suggests that rate cuts are not imminent either.

Markets have made this mistake before. At the start of 2023 futures priced rate cuts by the end of the year, and after the failure of Silicon Valley Bank in March traders brought them forward again. The Fed raised rates once more in July and has not cut since. The pattern of the market expecting relief and the committee delivering patience has held for two years.

Precedent from the 1990s

History suggests that when the Fed cuts without a recession, it cuts modestly. In 1995 and early 1996, after doubling rates in 1994, it trimmed the funds rate by a total of three quarters of a percentage point and then stopped. In 2019 it made three quarter-point insurance cuts and paused again. Six cuts in a single year have usually come only when the economy was contracting or a financial crisis was under way.

Who gains and who loses

If cuts arrive later and in smaller steps than futures imply, holders of short-dated Treasuries will take the first losses as two-year yields rise back towards the policy rate. Rate-sensitive stocks that rallied hardest in November and December, such as small companies with floating-rate debt and regional banks, would give back some of those gains. Savers in money-market funds would keep earning more than 5 per cent for longer, and the dollar would probably hold its value against currencies whose central banks cut sooner. Markets price similar relief in Europe, where the ECB's deposit rate stands at 4 per cent and Bank Rate at 5.25 per cent, so a patient Fed would not be an isolated disappointment.

What to watch

The committee meets at the end of January and again in March, and the statement after the January meeting will show whether the language about further tightening is dropped. Monthly readings of core inflation, services prices excluding housing and average hourly earnings will matter most. A string of payroll reports above 200,000 a month would push cuts back, while a rising unemployment rate would bring them forward.

An economy at full employment does not need six rate cuts and will probably not get them. Traders who priced in a March start should expect to push their forecasts back more than once this year. The likeliest path is a first cut around mid-year and a total nearer the Fed's three than the market's six, with short-dated bond yields rising as that becomes clear.