Navigating rate cuts: Fed caution vs. market optimism

A balancing act

A slew of Federal Reserve officials spoke publicly last week regarding future interest rate policy, all in agreement that they need more assurance that inflation is viably cooling before cutting rates. In a speech to the Ohio Bankers League meeting, Cleveland Federal Reserve President Loretta Mester voiced this concern saying, “It would be a mistake to move rates down too soon or too quickly without sufficient evidence that inflation was on a sustainable and timely path back to 2.00%,” echoing the Fed’s most recent policy statement. Mester is not alone in her sentiments — many other Fed officials agree and are treading lightly on the plan for rate cuts. Richmond Federal Reserve Bank President Thomas Barkin spoke candidly that his forecast for rate cuts is “uncertain” and, thus, “it’s a reasonable idea to be patient” before cutting too quickly. Federal Reserve Governor Adriana Kugler declared her caution in not wanting to start cutting interest rates just yet at her policy address last Wednesday. “If progress on disinflation stalls,” she reasoned, “it may be appropriate to hold the target range steady at its current level for longer.” The Federal Reserve is now in a balancing act — it doesn’t want to hold rates too high for too long, causing a severe economic slowdown; but it doesn’t want to cut rates too soon, allowing inflation to settle above the Fed’s 2.00% goal. The Central Bank’s shift in focus is twofold — deciding when to start cutting rates and how quickly.

In response to last week’s Fed speak and the continual market digestion of the prior week’s hot jobs report, the two-year and 10-year U.S. Treasury yields have been up about 27 basis points from the week prior.

More cuts for the market

While the Federal Open Market Committee (FOMC) members are hesitant to cut rates, the market continues to out-predict the Fed in the number of rate cuts this year. Namely, the market is predicting five rate cuts, while the Fed is only pricing in three. According to the CME FedWatch Tool, the market expects rates to be within the 4.00–4.25% range by the end of 2024, which is a stretch from the FOMC’s December median Federal funds rate projection of 4.60% (projections will be updated at March’s meeting). In the near-term, markets are mostly aligned with the Fed’s caution of cutting rates too soon as there is an 82.00% expectation of another hold in March, but more than half of the market is predicting a cut by May. Overall, markets are optimistic about the economy. The S&P 500 hit a record high of above 5,000 intraday last Thursday afternoon and opened that milestone on Friday morning. Markets seem confident that the Fed will soon bring the economy to the “soft-landing” they’ve been hoping for.

While the Fed and markets can do their best to project where rates will go in the future, their predictions can never be 100% accurate — history has proven it. Given this, and the high levels of economic uncertainty looming over the U.S. and global economies, many organizations are taking a fresh look at their interest rate hedging strategies. Because of the current inverted yield curve, it is still possible to lock in a lower fixed rate than the current floating rate. Below are swap rate indications as of Friday, February 9, at 10 AM ET, on one-month Term SOFR, effective February 29, 2024.

The week ahead

This week is much busier on the economic data release front. On Tuesday, CPI numbers for January will be released, followed by U.S. retail sales on Thursday and housing starts and PPI data on Friday. Markets are forecasting these numbers to cool from the month prior.