Time to Bet on Multiple Rate Cuts? Analysts Say It’s Too Soon
Federal-funds futures suggest investors are more convinced than ever that the Federal Reserve will lower interest rates multiple times by the end of the year. Economic data suggest that is too drastic a bet.
Who is right? It depends on how you read the numbers.
After the latest flare-up in trade tensions, fed-funds futures show the market pricing in a 22% chance of the Fed lowering rates twice by the end of 2019 and a 5.8% chance of the Fed doing so three times. That is up from 6.9% and 0.7%, respectively, a month ago, as well as around the highest odds yet this year, according to CME Group.
The numbers seem to stand at odds with economic data, which have shown a strong labor market, inflation expectations that are tame but not in free fall, and modest profit growth well into the economic expansion. After all, the last time the Fed cut rates was in December 2008 — when policy makers were in the midst of grappling with the worst financial crisis since the Great Depression and financial markets were tumbling.
So why are futures seemingly suggesting that the Fed is mere months away from multiple rate cuts?
Analysts say the answer is simple: Fed-funds futures are useful in gauging traders’ bets on the direction that interest rates will move (in this case, lower). But they are less helpful when it comes to predicting how many interest-rate cuts or increases there will be, since traders often take exaggerated positions to hedge against the potential that they are wrong.
“The market is overpricing the probability of a cut in the next few months, even if the direction of the move is definitely right,” said Jon Hill, vice president and interest-rate strategist at BMO Capital Markets.
The growing bets on lower interest rates stem from the widespread belief that the U.S. economy will cool over the next couple of years. After tax cuts helped spur a jump in growth in 2018, the pace of economic expansion has moderated this year, with economists surveyed by The Wall Street Journal estimating gross domestic product will rise 2.3% in 2019 from the year-earlier period.
Combined with lingering risks such as the U.S. and China’s trade conflict and slowing growth around the world, many investors are confident that the Fed’s next move will be a rate cut, not a rate increase. The belief has become so popular that some analysts have called it a crowded trade: a wager that is held by so many investors that, should the Fed end up unexpectedly reversing course and raising rates, its unraveling could exacerbate market declines.
Fed-funds futures currently point to a 25% chance of the Fed cutting rates in July, far sooner than most investors have called for. That reflects not a literal belief that there is a one-in-four chance of a July rate cut but a hedge against the possibility that interest rates might actually move lower, Mr. Hill said.
“The move to me shows we’re not sure about a cut in 2019, but we’re at least a lot more confident about it happening in 2020,” he said.
Few are expecting the next rate cut to happen imminently. While Washington and Beijing’s trade fight has spurred volatility in financial markets, stocks still r emain up double-digit percentages for the year.
Many believe there would have to be a far more severe slide to trigger the so-called Fed put: a scenario in which the central bank, seeking to stabilize markets, steps in and lowers interest rates. Fund managers surveyed by Bank of America in May say the S&P 500 would have to fall to as low as 2350, or 17% below current levels, before the Fed cuts rates.
“Lowering rates will create financial imbalances, not ‘win’ the trade war,” said Michael Farr, chief executive of wealth-management firm Farr, Miller & Washington, in emailed comments.
Plus, even though White House officials have been vocal about their desire for the Fed to cut rates, Fed Chairman Jerome Powell has signaled that he doesn’t see a strong case for moving rates lower or higher.
“Not only would a pre-emptive rate cut reopen questions of Fed independence, it would leave the central bank with less ammunition to fight a recessionary downturn later in the cycle,” said Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management, in a note.
Source: Dow Jones