Some investors are warning of a mismatch between market expectations and the Federal Reserve’s stated commitment to stamp out inflation as traders are hedging their bets on interest rate cuts next year.
Futures market traders are betting that the central bank’s main interest rate will be cut to 3.3% by the end of next year after peaking at 3.7% in March 2023. This implies that the Fed will have to cut rates for the second half of next year.
However, some investors argue that the market is misjudging the Fed, which has repeatedly said it intends to tackle inflation, even if tighter monetary policy leads to higher unemployment and slower economic growth .
“It’s, to me, blatant market mispricing,” said Rebecca Patterson, chief investment strategist at Bridgewater Associates. “Market participants are conditioned from previous cycles to expect the Fed to pivot” to a more dovish stance, he added.
The Fed’s most recent summary of economic projections, known as the “dots chart,” showed that most officials expect the federal funds rate to reach 3.8 percent by the end of 2023, before cutting- se to 3.4% in 2024. This forecast from June implies that there will be no rate cut next year. A new dot chart will be released next month.
Doubts about the Fed’s commitment to reducing inflation have been seeping in for months, as investors have wavered in their belief that the central bank will push ahead in the face of the slowdown.
But the Fed and its officials have stressed they are determined to tackle the highest inflation in nearly four decades. Mary Daly of the San Francisco branch said this week she was skeptical the central bank would cut rates next year.
“The worst thing you can have as a business or a consumer is for rates to go up and then go down quickly,” he said in an interview with CNN. “It just causes a lot of caution and uncertainty.”
He said it would be wrong to think about a “big, hump-shaped speed road, where we ramp up very quickly this year and then cut back aggressively next year.”
Also this week, St Louis Fed President James Bullard said he supported a third straight 0.75 percentage point hike in rates at the central bank’s next policy meeting in September.
Despite these protests, equity investors are skeptical that the Fed will follow through with a sharp increase in interest rates.
As the Fed embarked on an aggressive tightening cycle in March, US stocks fell into bearish territory as investors bet that higher borrowing costs would hurt businesses and consumers.
But the blue-chip S&P 500 and the tech-heavy Nasdaq Composite have recovered nearly half of their losses this year since June.
“There’s this disconnect between the market and the Fed, and there’s a sense that the Fed will have to ease back on its tightening program to allow for weaker employment and slower growth,” said Gregory Whiteley, managing director of DoubleLine portfolio. “This idea is very embedded in the markets.”
The recovery in stocks has eased financial conditions, making it easier for companies to borrow and hampering the Fed’s efforts to cool the economy.
A Goldman Sachs index shows US financial conditions have eased significantly since peaking in mid-June after the Fed’s first rate hike of 0.75 percentage points.