In a market twist, bond investors and rates traders are increasingly betting that interest-rate cuts will arrive sooner rather than later, challenging central bankers’ long-standing commitment to higher borrowing costs. Contrary to the central banks’ mantra of tight monetary policies for the foreseeable future, markets are now predicting that the Federal Reserve may initiate its first rate cut as early as June, with nearly 100 basis points of reductions anticipated by the end of 2024. Similar expectations are reflected in the European Central Bank, with potential cuts starting as soon as April. In the UK, the Bank of England is also seen reducing the benchmark rate by almost 70 basis points.
This shift in market sentiment could pose a challenge for central bankers, who have previously acknowledged that expectations of a prolonged period of tight monetary policy have contributed to higher bond yields, effectively cooling the economy.
Henry Cook, a senior economist at MUFG, warns that officials will aim to delay rate cuts as long as possible to prevent an easing of financial conditions. However, if economic data continues to worsen in the coming months, the central bankers’ stance will become increasingly difficult to maintain.
Market skepticism has grown since 2021 when central banks insisted that inflation would prove to be transitory. For rate setters, the decline in bond yields could ease financial conditions, potentially undermining the impact of the previously implemented rate hikes.
ECB Executive Board member Christine Lagarde has emphasized that discussions about cutting interest rates are “totally premature.”
Sebastian Vismara, a senior economist at BNY Mellon Investment Management, highlights the challenge of preventing the market from becoming overly enthusiastic. As long as there is no credible risk of a rate hike, the market is likely to continue pricing in rate cuts.
Recently, traders rushed to revise their expectations, moving the first anticipated US rate cut from July to June, following weaker-than-expected payroll numbers and rising unemployment.
There is a risk that this aggressive positioning by traders may backfire, as they have often been on the wrong side of the trade during this economic cycle. The market has frequently either prematurely called an end to rate hikes or priced in excessive tightening.
The US 10-year yield has dropped from 5% to 4.50% in less than two weeks due to expectations that rate hikes are over. This has raised concerns among central bankers about the rapid easing of financial conditions.
If financial conditions ease too quickly, central banks may have to intervene forcefully to reverse the trend, a move that could be self-defeating.
In the UK, despite inflation running at three times the 2% target, Bank of England Governor Andrew Bailey has insisted that it is too soon to consider rate cuts.
However, some strategists believe that the market pricing has jumped the gun, and investors have been too hasty in shifting their focus to rate cuts. Mark Dowding, Chief Investment Officer at BlueBay Asset Management, doubts that any major central banks will implement rate cuts for at least another nine months, given that inflation remains above target, and there are few signs of a significant weakening in the US economy.
In Canada, the central bank’s decision to keep the possibility of another rate hike open has been criticized, with some arguing that policymakers should already be discussing rate cuts.
David Zahn, Head of European Fixed Income at Franklin Templeton, suggests that bets on rate cuts in Europe from April may be premature. However, he believes that further in the future, the ECB may have to loosen policy more than currently priced in to support the economy.
It is becoming increasingly clear that central banks have finished hiking rates, and the focus is shifting towards preparing for a sustained rate-cutting cycle in Europe.
