Bond investors are pricing in imminent Federal Reserve interest rate cuts by the first half of next year, as signs of slowing U.S. economic growth and easing inflation became more evident.
While a weakening growth outlook is likely an important factor in keeping the U.S. central bank from raising rates, progress on the inflation front could determine when it will pivot toward monetary policy easing.
The release on Thursday of the latest U.S. personal consumption expenditures (PCE) price index, the Fed's preferred measure of inflation, could mark another step closer to that looming policy shift.
The PCE price index was unchanged in October after climbing 0.4% in September. In the 12 months through October, it rose 3.0%, the smallest year-on-year gain since March 2021 and a sharp drop from the 3.4% reading in September.
"The Fed is on hold, and (this report) gives them more comfort in staying on hold. What they're doing is working," said Robert Pavlik, senior portfolio manager, Dakota Wealth Management in Fairfield, Connecticut.
"The data is trending in the direction that the Fed wants to see," Pavlik said. "A 25- to 50 basis-point cut before the end of the summer 2024 would make sense as the economy slows down, for the Fed to fine tune how their policy tools are working."
Traders' confidence was reinforced earlier this week when Fed Governor Christopher Waller, a hawkish policymaker, flagged a possible rate cut in the months ahead.
Markets will be looking to Fed Chair Jerome Powell's remarks on Friday at Spelman College in Atlanta to see whether he doubles down on Waller's comments or pushes back.
Here is how Fed policy expectations are playing out in different corners of the bond and money markets:
FED FUNDS FUTURES
Federal funds futures are the most straightforward measure of determining of where traders believe the U.S. central bank's benchmark overnight interest rate will be in the future. That market has priced in about a 45% chance of a rate cut at the March 19-20, 2024 meeting, rising to about a 75% probability at the April 30-May 1 meeting, the CME FedWatch Tool showed on Thursday. Overall, the rates market sees a roughly 100 basis points (bps) of cuts by the end of 2024, according to LSEG data.
YIELD CURVE
The current yield curve measuring the gap between yields on U.S. two-year and 10-year Treasury notes has narrowed its inversion for the past several weeks. An inversion of this part of the curve is viewed by many as a reliable signal that a recession is likely to follow in one to two years.
But the yield curve has been reducing its inversion as investors start to price in the end of the Fed's tightening cycle. It was last at minus 38.50 bps .
Market participants referred to the yield curve's move in the last few weeks as a "bull steepener," a scenario in which short-term yields are falling faster than long-term ones. This often happens when the Fed is expected to cut interest rates, analysts said.
SOFR FUTURES
Bond investors also look to the Secured Overnight Financing Rate (SOFR) futures to gauge expectations of Fed rate moves. The March 2024 SOFR futures have priced in a 50% chance of a 25 basis-point cut at the March meeting.
The June 2024 SOFR futures have priced at least one Fed cut, while the probability of two 25-basis-point rate reductions was at 76%.
SOFR, a measure of the cost of borrowing cash overnight, replaced the prior benchmark rate, Libor, on June 30 after a rate-fixing scandal by bankers at several major financial institutions came to light in 2012. It's now the backbone of U.S. corporate borrowing.
OIS FORWARDS
The overnight index swap (OIS) forwards market, another corner of the fixed income market that shows traders' rate expectations, is also pricing in rate cuts starting in March.
An OIS transaction involves exchanging an overnight rate such as the federal funds rate for a fixed one. For instance, in a U.S. two-year OIS transaction, one party receives a fixed two-year rate in exchange for paying the fed funds rate daily over the next two years.
The three-month by six-month OIS forward is factoring more than a 40% chance of a 25-basis-point cut by the Fed's March meeting, LSEG data showed. The longer-dated six-month by nine-month OIS showed 100% odds of at least one rate cut by June, while the chances of two rate cuts by the middle of next year are at 78%.
