Since the beginning of 2024, investors have been primarily interested in when the Federal Reserve will start cutting interest rates.
Initially, March seemed like a good time to do this, but expectations then shifted to June after a wave of unfavorable economic data. Now, for the same reasons, the first rate cut may not happen until December, if at all this year, although UBS economists still expect a rate cut in September.
However, investment expectations do not actually depend on when the Fed will start cutting interest rates, but more on the path and destination after that, analysts at UBS said.
Analysts noted that the rally is up about 15% year-to-date despite the market price for 2024 cuts falling from about seven to less than two now.
“They made clear that what is important is that economic growth and profits have been better than expected. The first cut in September or December is unlikely to make any meaningful difference to either over the next year.”
“We therefore expect the debate over the pace, size and level of interest rate cuts to be front and center this summer, a point made clear in our second-half forecasts,” the analysts added.
This reflects a consensus of opinion on macro conditions in the rest of 2024, with most investors expecting moderate growth in GDP and inflation, low recession risks, and a realistic range of zero to two interest rate cuts. However, analysts noted that the range of potential outcomes for growth, inflation, fiscal policy and Fed rate cuts is much broader for 2025 and beyond.
When focusing on the interest rate path, in particular, the discussion is relevant to investment expectations for three main reasons, the note said.
First, fluctuations in the 10-year Treasury yield closely mirrored changes in market expectations for the neutral federal funds rate, suggesting that shifts in expected federal funds rate cuts could similarly affect the 10-year Treasury yield.
Second, the debate over the neutral federal funds rate (r*) and how restrictive current monetary policy is remains crucial. Opinions vary widely, with some arguing that policy is not too restrictive, while others argue that the neutral rate is around 3%.
“The resilience of the US economy favors the first view at present, but the rapid slowdown in growth may tilt it toward the second view,” the analysts wrote.
Finally, the lack of a clear framework from the Fed regarding the path of interest rate cuts is a source of potential market volatility.
While the Fed’s “dot charts” suggest a steady pace of cuts until the funds rate reaches 3% to 3.25% by December 2026, it remains uncertain how the Fed will respond to deviations from its growth forecast. And inflation.
As economic conditions evolve, we are likely to see significant fluctuations in expectations of interest rate cuts, which may contribute to market volatility.