Delayed rate cut anticipation: Possible market implications

Investor optimism for a Federal Reserve rate-cutting strategy, which was prevalent as recently as January to counteract significant policy tightening, has been tempered by three months of inflation data.

The consumer price index report for March, released Wednesday, has confirmed concerns that inflation is more persistent than initially anticipated. This has lent weight to the cautious approach of Fed policymakers and shattered market expectations of up to seven rate cuts this year.

Liz Ann Sonders, chief investment strategist at Charles Schwab, remarked, “The math suggests it’s going to be hard near term to get inflation down to the Fed’s target. Not that you’ve put a pin in inflation getting to the Fed’s target, but it’s not happening imminently.”

The Labor Department's CPI report did little to boost sentiment. Both the overall and excluding food and energy readings surpassed market consensus on a monthly and annual basis, pushing inflation rates well above the Fed’s 2% target. Headline CPI rose 0.4% for the month and 3.5% from a year earlier.

However, additional warning signals beyond the headline figures have surfaced.

Service prices, excluding energy, surged by 0.5% and were 5.4% higher compared to a year ago. A relatively new calculation that the markets are closely monitoring, known as "supercore" (which involves core services minus housing), saw a significant increase at an annualised rate of 7.2% and rose by 8.2% on a three-month annualised basis.

There is also the risk of "base effects," where comparisons to previous periods may make inflation appear even more severe, especially with energy prices rising after a similar fall around the same time last year.

All of these factors have left the Fed in a wait-and-see stance, causing market concerns about the possibility of no rate cuts this year.

Traders now view the likelihood of a cut at the June meeting as slim, which was previously favoured. They have also pushed back expectations for the first reduction to September, now anticipating only two cuts by the year's end. Traders have even factored in a 2% probability of no cuts in 2024.

"Today's disappointing CPI report complicates the Fed's task," stated Phillip Neuhart, director of market and economic research at First Citizens Bank Wealth. "While the data doesn't rule out Fed action this year entirely, it certainly reduces the likelihood of the Fed cutting the overnight rate in the next couple of months."

Naturally, the CPI news was met with disapproval from the markets, leading to an aggressive sell-off Wednesday morning. The Dow Jones Industrial Average plunged by over 1%, and Treasury yields surged. The 2-year Treasury note, known for its sensitivity to Fed rate changes, spiked to 4.93%, marking an increase of nearly 0.2 percentage points.

There may still be positive developments on the horizon for inflation. Factors such as improving productivity and industrial capacity, along with a slowdown in money supply growth and easing wage pressures, could alleviate some of the strain, according to Joseph LaVorgna, chief economist at SMBC Nikko Securities.

However, LaVorgna added, “Inflation will likely remain higher than necessary to justify Fed easing. As such, expectations for Fed rate cuts are likely to be pushed further into the second half of the year, possibly only amounting to a 0.5% reduction, with risks leaning towards even less easing.”

In many ways, the market has itself to blame.

The initial pricing-in of seven rate cuts earlier this year was starkly at odds with signals from Fed officials. However, when policymakers in December adjusted their “dot plot” projection from two rate cuts in September to three, it triggered a frenzy on Wall Street.

“The market was overly optimistic in that assumption. It didn't align with the data,” noted Schwab’s Sonders.

Nevertheless, Sonders believes that if the economy maintains its strength — with GDP projected to grow at a 2.5% rate in the first quarter, according to the Atlanta Fed — the knee-jerk reaction to Wednesday’s data could subside.

“If the economy holds up, I believe the market will generally be okay,” Sonders remarked.

 

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