By Michael O’Neill

It seemed like a sure thing. Bet the farm on not just the Fed cutting interest rates in 2024 but bet on them to be cut deeper and faster than previously expected. Everyone was doing it.

By the end of December, traders and analysts were fully vested in the belief the Fed’s first rate cut would occur in March. The US 10-year bond yield had touched 3.79% and had been below 3.89% since the middle of December. The CME FedWatch tool odds for a March rate cut were in the 77% area on January 12. The US dollar index started the year around 101.90. Life was good.

The Tide Turns

And then it wasn’t! Literature is awash in cautionary adages. “There is no such thing as a free lunch, Don’t count your chickens before they hatch, and in honor of the Lunar New Year, Don’t count your eggrolls before they are deep-fried.” Unfortunately, they were not on the radar for many traders.

The Fed’s so-called “pivot” at the December 13 FOMC meeting created the furor about rapid and steep rate cuts occurring in 2024, despite projections, and Fed official comments to the contrary. At the time, Fed Chair Jerome Powell said “While we believe that our policy rate is likely at or near its peak for this tightening cycle, the economy has surprised forecasters in many ways since the pandemic, and ongoing progress—sorry—ongoing progress toward our 2 percent inflation objective is not assured. We are prepared to tighten policy further if appropriate.”

Many traders only heard “rates have peaked.”

Traders also turned a deaf ear to Mr. Powell’s, and other Fed officials’ warnings that “We will continue to make our decisions meeting by meeting, based on the totality of the incoming data and their implications for the outlook for economic activity and inflation, as well as the balance of risks.”

Economic Data Challenges Rate Cut Expectations

Well, the US data since the beginning of the year has not been very “rate cut” friendly. January Retail sales were far higher than expected, housing starts beat forecasts, and the economy grew at 3.3% in Q4, far faster than anticipated. Traders started getting nervous and slowly and reluctantly began covering positions. The January blow-out nonfarm payrolls numbers really spooked the market, but it was the January inflation data (released on February 13) that was the “jump out the window” moment.

The dust is still settling on the debacle caused by the latest NFP and CPI reports, but there is no doubt that those numbers are not conducive to the Fed cutting rates any time soon. But the operative word is “soon.”

The market reaction was somewhat exaggerated because the “whisper guesses” prior to the data suggested that CPI would fall even further than expected. Lost in translation was that inflation did fall, just not as much as expected. Core Inflation was unchanged.

In addition, there are many different metrics measuring inflation, and reportedly, the Fed’s preferred measure is the Core Personal Consumption Expenditures Price Index. Those results were better than expected for December.

Looking Ahead

The December Summary of Economic Projections suggested three 25 bps rate cuts in 2024. That is still likely. What is unlikely is the 150 bps that many traders were expecting. The Fed spent the last two quarters of 2023 setting the market up for an end to rate increases. Mr. Powell confirmed as much in his January 31 press conference opening statement. “We believe that our policy rate is likely at or near its peak for this tightening cycle.”

The bar is set really high for the Fed to pivot back to hiking rates.

Plan B

The Federal Reserve’s plans for at least three interest rate reductions in 2024 suggest it’s reasonable to expect the 10-year Treasury yield to dip below 4.00% and the US dollar to weaken. However, the exact timing remains uncertain.

Traders typically position themselves in anticipation of such shifts, often well before the events occur, to maximize gains. Although the first rate cut might not happen until June, there’s a historical pattern of the US dollar weakening during March, April, and May. Should this trend persist, speculation about upcoming rate cuts could intensify these movements. This scenario could also lead to a softer USDCAD, potentially staying within the 1.3200-1.3600 range that has been in place since December 7.

 Essentially, what seems like a certain outcome is just a plan that might need to adapt to new circumstances, turning Plan B to Plan C.