Fed Chair Jerome Powell tried to push back on near-term rate cut expectations, but markets shoved right back. Pricing suggests markets are concerned that if the Fed waits too long to cut rates policymakers will only have to cut them more.
February 1, 2024
Thomas Garretson, CFA Senior Portfolio StrategistFixed Income StrategiesPortfolio Advisory Group – U.S.
What was widely expected to be a rather uneventful first Federal Reserve meeting of the year proved to be anything but. Though heightened market volatility around it may have been amplified by other events this week, the Fed’s relative reluctance to formally open the rate cut window sparked some interesting market reactions.
While most would probably argue that the Fed was a bit late to the rate hike party in 2022, the underlying risk for markets – and the economy – is that it could also be late to the rate cut party. To be sure, Powell this week acknowledged the risks of cutting too late, especially as inflationary pressures have receded more rapidly than policymakers had expected late last year. But the market reaction this week suggests that risk remains – if not even more elevated.
Powell’s comments were successful in culling market pricing of a March rate cut with probabilities fading to roughly 30 percent from a peak closer to 90 percent in January. But markets simply took that and ran with the idea that a later start to rate cuts might only mean that a greater number of cuts are ultimately needed. Prior to Powell’s comments, markets were pricing in about five 25 basis point rate cuts to around 4.1 percent by the end of the year; now markets are pricing deeper cuts to around 3.8 percent.
And this dynamic is pressuring Treasury yields lower. The benchmark 10-year Treasury note yield has faded to just 3.8 percent (in line with rate cut expectations) from a 2024 peak of 4.2 percent achieved one week ago, and notably down from the 2023 high of five percent. A break below 3.8 percent would mark the lowest level since this past July.
The line chart shows the expected level of the U.S. federal funds rate, relative to the current 5.3%, in the fourth quarter of 2024, according to four sources: the Federal Reserve’s own projection (4.6%), Bloomberg consensus (4.3%), RBC Capital Markets (4.1%), and the projection based on current market pricing (3.8%).
Source – RBC Wealth Management, Bloomberg; data as of 2/1/24, forecasts shown for Q4 2024
We would be the first to concede that getting a clean read on the market’s interpretation of the Fed meeting this week was certainly clouded by market stress elsewhere. Specifically within regional banks as New York Community Bancorp’s (NYCB’s) stock price fell by half following its Q1 earnings report where the dividend was cut by 70 percent.
A drop of that magnitude sparked broader selling pressures within the regional banking sector, raising investor concerns that the ghosts of banking stress that visited markets last spring could be coming back to haunt again.
However, our early read is that this is a localised event and not a harbinger of another round of broader regional banking stress on par with what markets weathered last year. RBC Capital Markets analysts noted: “Results had several negative surprises, including a higher-than-expected provision and reserve build, a meaningfully lower margin and outlook, and a dividend cut announcement. We believe that many of these trends are related to the company crossing the $100 billion asset mark and becoming a Category IV financial institution, which is driving increased liquidity and compliance needs, though in aggregate the results were less than expected. The 2024 outlook also suggests some further margin and expense pressures due to these themes.”
Turning back to the Fed and where things might go from here, we think inflation is still the name of the game. This is perhaps also where the greatest disconnect between Powell’s comments and current market sentiment lies.
We think the clear takeaway is that the Fed still wants even more evidence, and greater confidence, that inflation is on a firm path back to two percent. In our view, it is. Core Personal Consumption Expenditures Inflation (excluding food and energy) has been running below the Fed’s two percent target over the past three and six months, at 1.5 percent and 1.9 percent annualised, respectively. While Powell somewhat dismissed those numbers and fell back to highlighting the year-over-year pace at a still-elevated 2.9 percent, we do think the Fed is closer to the point of declaring victory than policymakers are letting on. We remain highly certain the Fed won’t wait until annual inflation is back to two percent, as by then it would be far too late. Markets perhaps just wanted more acknowledgment of recent inflation progress.
Other data released this week showed another sharp drop in consumer inflation expectations. As shown in the last chart, one-year inflation views have almost unwound all of the rise over the past two years, and are now in line with historically standard levels.
The line chart shows, for the period of 2014 to January 2024, the deviation of consumer inflation expectations over a one-year time horizon from the median level over that period. The deviation was largely negative by 0.5% or less until mid-2020, when it suddenly rose to 1.5% above the median. Consumer expectations reached a maximum of almost 3.5% in mid-2022, and have since trended downward to 0.1% in January 2023.
Source – RBC Wealth Management, Bloomberg, Conference Board Consumer Confidence Survey; monthly data, 12/31/14–1/31/24
The Fed’s goal of approaching the “highly consequential” decision to begin cutting rates “methodically and carefully,” as various policymakers have recently suggested, may seem prudent on the surface, we – and the market – clearly want a more deft and flexible approach if the Fed is going to pull off a soft landing for the economy. We think the Fed will get there, even if it has stumbled out of the gate.
We think there is 50 percent chance a March rate cut will occur based on the incoming data, but, at a minimum, the meeting will likely set the stage for a May cut, with more to follow this year.
This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.
The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.
This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.
Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only.
We want to talk about your financial future.