By Mike Dolan
LONDON (Reuters) – If the first cut is the deepest, timing will be everything.
For all the rhetorical pushback from officials, markets are doggedly clinging to March as the month of the Federal Reserve’s first interest rate cut in four years – following two years of historically brutal credit tightening.
Even though futures pricing for a move has ebbed and flowed over the weeks since Fed policymakers electrified markets last month by pencilling 75 basis points of cuts for 2024, they have consistently assigned a 50% or greater chance of a move as soon as March.
But listening to the full sweep of Fed speakers, that seems brave.
Officials couch the policy horizon in a bit of fog as they greedily gather more data to support a critical switch of direction – but more and more point to a first move from midyear on, with some even retaining the option of one final hike.
Once again on Tuesday, the implied probability of a March cut moved as high as 75% early in the day – only to slip back again after governor Christopher Waller acknowledged the Fed’s 2% inflation goal was within striking distance but doused any need to be ‘rushed’ with a first rate cut while assessing the ‘coming months’ of data.
The relatively gentle rap on market knuckles elicited an equally modest response and futures stayed roughly 70% priced for a March move.
All of which may sound like a familiar old story of irrational market exuberance and foolishly fighting the Fed.
Perhaps.
But the obsession with March is not without foundation.
Aside from the curious fact that March has lately become a bit of milestone month for the Fed – it was the month of the final cut in 2020 and the month it started tightening in 2022 – there are good reasons why futures won’t give up the ghost.
WEDGES AND TARGETS
Last week’s U.S. consumer price report for December lit a fire under March bets despite headline readings initially suggesting it was another obstinate inflation picture the Fed seems to be so cautious about.
But combined with the following day’s benign producer input data, breakdown of the CPI and PPI reports showed very soft readings for components in both that hold larger weightings in the Fed’s favoured personal consumption expenditures (PCE) inflation gauge – the December version of which is due on Jan 26.
A ‘wedge’ between CPI and PCE appears to be widening.
So much so that many banks and traders slicing and dicing inflation stats quickly homed in on the likelihood that six-month annualised ‘core’ PCE inflation is now falling below the Fed’s 2% target.
That price picture was enough to prompt Barclays this week to bring forward its forecast for the first Fed rate cut to March from June – as it now sees annualised core PCE for the second half of 2023 as low as 1.9% compared with an equivalent CPI measure still over 3%.
UBS economists similarly now see the six-month annualised core PCE inflation rate as low as 1.8% – almost a third of its peak at 5.9% in March 2022.
And while many forecasters warn these measures could pop back slightly above 2% again in the first few months of 2024, most, including Morgan Stanley, are also cutting their full year 2024 core PCE outlooks.
These shifting sands mean that, regardless of the date of the first cut, the total amount of easing priced for 2024 has now moved consistently back above 150 basis points (bps) – twice Fed indications from last month and 15 bps up from the start of January.
And many also point out that if you watch other momentum indicators – three-month or even one-month annualised core PCE rates – they have been under 2% since the middle of last year.
“Eventually the Fed is going to realize that it is behind the curve, just as it did on the other side of this cycle,” wrote Tim Duy of SGH Macro Advisors. “The Fed can maintain all it wants that ‘inflation is still too high’ but that’s just a delusion that ignores the fact that inflation has been actually running at or below target for seven months.”
LAGS, WALLS AND REPOS
If on that basis, inflation has already subsided to or below target, then the ‘real’ inflation adjusted Fed policy rate is still rising into a slowing economy – despite the fact Fed minutes expressed concern about overtightening.
Even though the nominal Fed policy rate has been steady in the 5.25 to 5.5% range since July, the real Fed policy rate derived from a six-month annualised core PCE has risen an additional 130 bps to more than 3.60% in the interim and could rise further as these inflation rates subside further.
The Fed may then be pressured to cut the nominal rate just to stop rising real rates squeezing the economy excessively. That’s doubly so because assumptions of one-year-plus lags in policy transmission means it may already be wary of so-called maturity walls in corporate debt refinancing schedules that are assumed be hit early next year.
Another factor arguing for an early move is interpretation of Fed rhetoric.
What’s clear from the December meeting is that without any rhetorical shift in the cautious statement or comments from Fed Chair Jerome Powell, policymaker forecasts had shifted regardless.
For many, that signalled that ‘Fedspeak’ can comfortably reconcile phrases like higher-for-longer and restrictive policy with nominal policy rate cuts as long as rates remain above the 2.5% it sees as long-term neutral.
What’s more, the minutes of the Fed meeting have already flagged some concern about the rapid drain of excess liquidity in the money markets as cash parked at the Fed’s reverse repo facility overnight falls away.
Fed officials now appear agreed on at least a discussion about the parameters of a slowdown in its balance sheet runoff – or quantitative tightening policy – as a result.
Perhaps not coincidentally, if the pace of reverse repo drop of recent months is sustained through the early part of this year, it will have been run dry by March and leave banks open to liquidity shortages the Fed will be mindful of.
Betting on a March easing may prove wide of the mark in the end – and there are price risks that could shift the dial by then. But it’s not unthinking or outlandish and won’t go easily.
The opinions expressed here are those of the author, a columnist for Reuters.
(Reporting by Mike Dolan; editing by Jonathan Oatis)
Comments