When Will the Fed Cut Rates?
Between the U.S. Federal Reserve ending its tightening cycle to questions about America’s balance sheet and how that could affect the yield curve, the deficit, and the mortgage market, there’s a lot to digest in the interest rate market today.
Ian Lyngen, Head of U.S. Rates Strategy at BMO Capital Markets, broke down the challenges facing central banks and what they could mean for the year ahead at the BMO Insurance Distribution Forum.
Timing the Fed
Markets continue to fight the Fed around the expected timing of its first rate cut. The market has a strong tendency to price in future rate cuts as quickly as possible, he says. The problem is that investors think the Fed will react as it has during past slowdowns and slash rates, he adds.
But while traders are anxious to see the rate cut cycle begin, with the futures market pricing in a rate cut as early as March, the Fed doesn’t feel the same sense of urgency. In December, the FOMC Committee alluded to in a press release that inflation must come down to its 2% target before cutting rates, a number that has yet to be achieved.
This disconnect is one of the reasons why the shape of the yield curve remains inverted, says Lyngen, adding that he expects treasuries to be volatile through the first two quarters of the year. The first quarter will be “bond bearish,” which he says is partially due to seasonality in the treasury market and inflation data. By the end of the year, Lyngen expects the two-year year treasury to drop to 3% from the 4.3% it’s at now, while 10-year yields will dip to 3.5% from 4.1% today.
“At the end of the day, rates are going to be about where they were before COVID,” he said. It’s a remarkable accomplishment, he added, considering the decade’s high inflation levels and hawkish response from policymakers.
Easing Monetary Policy
If not in March, when could those cuts begin? Lyngen said he expects the Fed to begin the process of normalizing rates no earlier than June or July of this year, leading to 75 basis points in total cuts, dropping rates to about 4.5%.
To understand Fed Chair Jerome Powell’s “great delay” behind lowering rates, Lyngen points to the unemployment rate. The Fed sees unemployment peaking at 4.1%, which assumes the market won’t see the typical shift in the trajectory of hiring or layoffs across the broader economy outside of a few industries, he explains.
Even if unemployment edges higher, as Lyngen expects, although not enough to trigger a hard landing, the economy has been able to absorb the Fed’s aggressive actions over the past few years. That’s remarkable given how tight monetary policy is at this moment, with real rates at their highest level since 2007. The positive news is that there is growing evidence that the steps the Fed has taken to fight inflation are starting to take hold.
Unwinding the Balance Sheet
A lot of the inflationary effects had to do more with shifting behaviors around people moving to rural areas or buying a second car and, later, the surge in travel at any cost after being holed up at home. “None of that had anything to do with monetary policy, with perhaps the exception of lower mortgage rates,” he said.
Markets need to start contemplating the timing and the way the Fed will let the balance sheet unwind. If the Fed stops tapering quantitative tightening, the mortgage market is still going to be invested in treasuries, which could impact mortgage spreads, he explained.
The priority for the Fed is to make sure it has adequate reserves to protect the banking system, which is why they want to start unwinding the balance sheet to lower its bond holdings, said Lyngen.
“The less the balance sheet is unwound, the less the treasury department needs to tap the private market for funding,” he explained. “So, anything that isn’t retired off the Fed’s balance sheet effectively goes back into funding the U.S. deficit, the less public debt issuance from the Treasury Department.”
Lyngen is confident the Fed will do everything it can to reestablish price stability. “If the Fed is able to start normalizing rates in the second quarter without a spike in the unemployment rate, without any material deterioration of risk assets, then the path to return to neutral without a major dislocation becomes a lot clearer and a lot more achievable,” Lyngen says.
Listen to Ian Lyngen’s Macro Horizons podcast each week as he discusses the U.S. Rates market and more.
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Ian Lyngen
Head of U.S. Rates Strategy, BMO Capital Markets
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Between the U.S. Federal Reserve ending its tightening cycle to questions about America’s balance sheet and how that could affect the yield curve, the deficit, and the mortgage market, there’s a lot to digest in the interest rate market today.
Ian Lyngen, Head of U.S. Rates Strategy at BMO Capital Markets, broke down the challenges facing central banks and what they could mean for the year ahead at the BMO Insurance Distribution Forum.
Timing the Fed
Markets continue to fight the Fed around the expected timing of its first rate cut. The market has a strong tendency to price in future rate cuts as quickly as possible, he says. The problem is that investors think the Fed will react as it has during past slowdowns and slash rates, he adds.
But while traders are anxious to see the rate cut cycle begin, with the futures market pricing in a rate cut as early as March, the Fed doesn’t feel the same sense of urgency. In December, the FOMC Committee alluded to in a press release that inflation must come down to its 2% target before cutting rates, a number that has yet to be achieved.
This disconnect is one of the reasons why the shape of the yield curve remains inverted, says Lyngen, adding that he expects treasuries to be volatile through the first two quarters of the year. The first quarter will be “bond bearish,” which he says is partially due to seasonality in the treasury market and inflation data. By the end of the year, Lyngen expects the two-year year treasury to drop to 3% from the 4.3% it’s at now, while 10-year yields will dip to 3.5% from 4.1% today.
“At the end of the day, rates are going to be about where they were before COVID,” he said. It’s a remarkable accomplishment, he added, considering the decade’s high inflation levels and hawkish response from policymakers.
Easing Monetary Policy
If not in March, when could those cuts begin? Lyngen said he expects the Fed to begin the process of normalizing rates no earlier than June or July of this year, leading to 75 basis points in total cuts, dropping rates to about 4.5%.
To understand Fed Chair Jerome Powell’s “great delay” behind lowering rates, Lyngen points to the unemployment rate. The Fed sees unemployment peaking at 4.1%, which assumes the market won’t see the typical shift in the trajectory of hiring or layoffs across the broader economy outside of a few industries, he explains.
Even if unemployment edges higher, as Lyngen expects, although not enough to trigger a hard landing, the economy has been able to absorb the Fed’s aggressive actions over the past few years. That’s remarkable given how tight monetary policy is at this moment, with real rates at their highest level since 2007. The positive news is that there is growing evidence that the steps the Fed has taken to fight inflation are starting to take hold.
Unwinding the Balance Sheet
A lot of the inflationary effects had to do more with shifting behaviors around people moving to rural areas or buying a second car and, later, the surge in travel at any cost after being holed up at home. “None of that had anything to do with monetary policy, with perhaps the exception of lower mortgage rates,” he said.
Markets need to start contemplating the timing and the way the Fed will let the balance sheet unwind. If the Fed stops tapering quantitative tightening, the mortgage market is still going to be invested in treasuries, which could impact mortgage spreads, he explained.
The priority for the Fed is to make sure it has adequate reserves to protect the banking system, which is why they want to start unwinding the balance sheet to lower its bond holdings, said Lyngen.
“The less the balance sheet is unwound, the less the treasury department needs to tap the private market for funding,” he explained. “So, anything that isn’t retired off the Fed’s balance sheet effectively goes back into funding the U.S. deficit, the less public debt issuance from the Treasury Department.”
Lyngen is confident the Fed will do everything it can to reestablish price stability. “If the Fed is able to start normalizing rates in the second quarter without a spike in the unemployment rate, without any material deterioration of risk assets, then the path to return to neutral without a major dislocation becomes a lot clearer and a lot more achievable,” Lyngen says.
Listen to Ian Lyngen’s Macro Horizons podcast each week as he discusses the U.S. Rates market and more.
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