PERSPECTIVE3-5 min to read

Markets may be too optimistic about the scale of future US interest rate cuts

A recession, not a soft landing, would be necessary for the Fed to reduce rates at the level markets are expecting

02/01/2024
fed-building

Authors

Adam Farstrup
Head of Multi-Asset, Americas

The Fed “pivot” may not be that dramatic of a change

The US Federal Reserve (Fed) left its benchmark interest rate unchanged at the December 2023 Federal Open Market Committee (FOMC) meeting and signaled it might cut rates three times in 2024. US equity markets immediately rallied, with the Dow Jones Industrial Average surging to a record high. Bond markets rallied, too, as the yield on the 10-year Treasury fell below 4% for the first time since August.

While the Fed’s latest forecasts did constitute a significant shift in its near-term expectations for rate cuts, its views on where rates may be further out in this cycle did not depart from what it had already been signaling. From September to December, the median of the dot plots (the FOMC members’ projections of where rates will be) for 2024 declined by 50 basis points. The projections for rates in 2025 were also lowered. For 2026 and beyond, however, the FOMC member’s projections in December were in line with what they, collectively, had already forecast. The much-reported Fed “pivot” did come but only in its view of where rates will be in the near term.

The Fed’s December pivot only occurred in its near-term rate forecasts

Graph 1 - Adam F article on market being too optimistic about Fed rate cuts
Source: LSEG Datastream

The market appears to be expecting deeper rate cuts

While the Fed’s projected cuts would be meaningful, the market’s reaction indicated it was pricing in cuts for 2024 at twice the pace that the Fed signaled. That scenario would play out, however, only if US economic growth slowed to a much more dramatic degree than the soft landing (a slowdown without a recession) that the Fed seems to be anticipating.

To meet the market’s expectations, the Fed in 2024 would likely have to lower rates in increments of 50 basis points two or more times. For the Fed to take that level of dramatic action, the economy would have to experience a hard landing with far more extreme conditions such as negative growth and weak employment.

Moderate inflation likely to keep rates high, relative to the 2010s, through this cycle

While the market may be anticipating significantly lower rates, the Fed’s projections align with Schroders’ expectations that a steep, cumulative reduction in rates over the next several years is unlikely. We foresee challenges in the years ahead from the inflationary pressures of the 3D Reset. The demographic changes of aging populations and shrinking workforces will most likely bring continued pressure on wages as companies increasingly compete for workers, and technology-driven productivity gains may not arrive soon enough to offset those higher labor costs. The expenditures companies will have to make to meet decarbonization goals and the increased expenses associated with onshoring or near-shoring suppliers in the new era of deglobalization will also spur inflation.

Even if the Fed were to reduce the federal funds rate below its year-end 2023 range of 5.25%-5.50% to the 3% level by 2026 and to 2.5% by 2027 and beyond, the lows for the policy rate in this cycle are still likely to be the highs of the past cycle.

The ceiling for rates in the past cycle could be the floor in this cycle

Graph 2 - Adam F article on market being too optimistic about Fed rate cuts
Source: LSEG Refinitiv, December 2023. Historical trends are not a guide to future results.

Inflation is also likely to remain high around the world. The previous decade’s yearly inflation numbers of 1.6% and 1.9% are unlikely in the current environment. At Schroders, we’re even a bit more hawkish than the Fed is, expecting that the global inflation rate will hover at 3.0% annually into 2024 and 2025. In our view, it seems inevitable that real (post-inflation) interest rates will, on average, remain meaningfully higher over the course of this current cycle than they were in the previous decade and the very different climate that prevailed in the aftermath of the Global Financial Crisis and before the pandemic.

Fed’s year-end 2023 move aligns with Schroders’ baseline scenario for global economy

Graph 3 - Adam F article on market being too optimistic about Fed rate cuts
Source: Schroders Economic Group. 21 November 2023. Forecasts and assumptions may be affected by external economic or other factors. Forecasts in Q3 2023: global growth +2.5% (2023) and +2.1% (2024), global inflation 4.4% (2023) and 3.1% (2024). Forecasts may not be realized.

Monetary policy across the globe is likely to diverge

One of the key investment themes we expect to see play out in 2024 and beyond is a global divergence in monetary policy. Central banks around the world will have to respond at different paces and intensity because of the unique growth challenges and inflation conditions at play in their countries.

Rate cutting by central banks not likely to be in sync



Graph 4 - Adam F article on market being too optimistic about Fed rate cuts
Source: Refinitiv, Schroders Economics Group, 17 November 2023. Forward-looking views and forecasts may not be realized.

Inflationary pressures in Europe, for example, were far more driven by external influences than in the United States. Europe saw a spike in energy prices, largely because of the supply problems created by the war in Ukraine. The US didn’t experience the same degree of energy price increases in part because it has benefited from its natural gas resources. There are also differences across regions in labor supply, and the impact it can have on inflation. The US economy has been able to run at a level close to its full capacity, with low unemployment and lower than expected labor inflation, thanks to the flexibility of the US economy and labor force.

Investors will have to watch how these scenarios play out and what policy decisions central bankers make to respond to them. At Schroders, we are determined to help our clients find solutions that will enable them to prepare for, and effectively respond to, all the changes occurring across global markets.


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Authors

Adam Farstrup
Head of Multi-Asset, Americas

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