Interest rate futures continued to weaken last week and now price as the mean of the probability distribution that the Fed will cut just 3 ¼ times (assuming 25 bps each time) by the end of the year. The implied modal outlook is probably lower, given that the skew presumably remains to the left. So, the market is now in line with what the Fed dots said in December and what senior Fed officials continue to imply is likely to be the best guess as of the March 20 FOMC Summary of Economic Projections. As recently as early January, the market was looking for the Fed to go about twice as fast this year, as the chart below shows.
Expected 2024 rate cut has been cut in half
Data are to close Friday.
Financial conditions have not tightened much in response to repricing of the Fed. Indeed, both the daily version of the Fed’s FCI-G, which I work up, and Goldman’s FCI are near their easiest points for this episode, although the Goldman formulation looks slightly easier in level terms, relative to its own longer history. There are two reasons for this. First, risk asset prices have remained strong, despite the repricing. This fits my earlier view that lower inflation, relative to say six months ago, raises the speed limit for growth and thus perhaps the fair-value of risk asset prices for any given funds rate path. The recently stronger price data reduce the urgency for Fed ease, but don’t move the speed limit much, as I have been emphasizing. Moreover, the growth data themselves have recently been generally strong. So, this fits, although it may be a bit bold to tell a story to rationalize a two week move – or non-move – in asset prices. Fluke is usually the best answer.
Second, the beta of longer-duration interest rates to the nearby funds rate path is simply not very high. So, even without the strength in risk asset prices we should not have expected much movement of measures of financial conditions indexes. What excites us on a week to week basis is generally noise when thinking of a horizon that is relevant to the effect of asset prices on economic conditions, which is what these indices try to capture.
Financial conditions seemingly remain easy or at least non-tight practically speaking
Data are actual to Friday close.
The most straightforward implication of this is that we should probably continue to look for a further hawkish repricing of the short end in order to nudge financial conditions tighter, as would seem to be required to limit demand growth to its potential rate or to slightly below, as would seem to be the Fed’s preference. The speed limit is higher than it was, and the Fed has had the luxury for a while now of risk managing against recession as well as against inflation. And that has mattered for risk assets. The speed limit is not that high, and the demand indicators have been generally solid.
The problem for me, though, is that the repricing at the short end is not likely about the market coming to my view of how things work. Rather, the Fed leadership has apparently been on a mission to prevent a further easing of financial conditions, by insisting that they are likely to ease belatedly and slowly. That seems right to me. But to state the obvious, investors have been listening to the Fed, not my arguments. And it seems unlikely that Fed rhetoric will toughen even further from here unless the data surprise to the upside. One reason among several is that the Fed still lets on at least that they view monetary policy as tight. Not sure why, but they do.
Separately, but perhaps reinforcing, equities now look about as expensive as they did before the GFC. So, it is possible they might start acting a bit more sensitive to any incremental rates hawkishness from here. This is not the main point, but it seems worth mentioning.
Finally, last week was quiet on the data front, which allowed Fed talk to dominate. But this coming week, might be the opposite, as there are several important indicators due, all of which have the potential to surprise. So, it might be prudent to watch, wait, and perhaps hope for a misinterpretation (by my lights) of the news about to come.
