It was quite the turnaround. At the end of last year, futures markets had priced in six interest rate cuts for the US in 2024. As stubborn inflation data kept coming in over the first quarter, traders began to slowly align with the US Federal Reserve’s forecast for just three. But, over the past two weeks, those still expecting several cuts this year have started to look like stubborn contrarians.
A third above-expectation reading for US consumer price index inflation in March was the final straw. Traders repriced to between one and two rate cuts this year — although zero is an increasingly popular punt too. The moves forced Fed chair Jay Powell into a volte-face on Tuesday. He admitted that rates may need to stay higher to tame inflation. Just a few months earlier, he had struck a more sanguine note that cuts were coming into view. What does the shift mean for the economy?
Financial markets remain vulnerable to higher futures pricing. After over-optimistically betting on six quarter-point cuts, investors dived into equities and other riskier assets. The S&P 500 rose about 15 per cent in the four months to April. But stocks have started falling as the updated rate narrative has burst traders’ bubbles. It also means concerns throughout this rate-raising cycle — such as unrealised losses on balance sheets, high real estate debt and hidden leverage in private capital markets — have not gone away.
For now, the broad impact on households and business could be muted. Both have largely locked in lower fixed rates, explaining some of the resilience in the US economy.
At the end of 2023, about 70 per cent of mortgage holders had rates more than 3 percentage points below the market rate. But those taking out new loans and with hefty credit card balances will be even more strained. Delinquencies are edging up.
The stark shift in rate expectations has policy implications outside the US too, having led to a jump in the dollar. For the European Central Bank and the Bank of England, which recently signalled that they could cut policy rates before the Fed, the relative decline in the euro and pound — which adds to inflationary pressures — complicates their considerations. Asian currencies also suffered a sharp sell-off, with the yen dropping to its weakest since 1990. Markets are on high alert for possible currency interventions by the authorities in Japan and South Korea.
This leaves Powell in a pickle. Annual US core inflation is practically the same as it was in December. Yet it is not patently clear that the disinflation process has ended either. Price pressures today come from a narrower bundle of items — including housing and insurance. Signs of a cooling labour market point to an easing in sticky services inflation. Holding rates for too long could turn the cracks in America’s sturdy economy into a chasm.
Narratives matter as much as the actual economics, however. After drumming home that the Fed will be “data-dependent”, the bar to convince markets that rate cuts are warranted will be high. Powell could make clearer what data the Fed is focusing on, and outline its thinking on medium-term trends; with that anchor, markets might start to look through the bumpy monthly inflation figures. But if the Fed itself is not clear on the direction of travel, more transparency can do more harm than good.
Israel’s retaliatory strikes on Iran overnight underscore how the economic outlook continues to be blurred by geopolitics. In uncertain times, investors are best advised to be cautious. But markets also look to the Fed for guidance. Powell has the thankless task of trying to communicate convincingly amid uncertainty. His tone, choice of words, and each inflationary subcomponent will be scrutinised until a believable economic story emerges. Volatility is here to stay. Interest rate narratives have switched once; they could switch again.