Will the Fed be the last to cut?

Market expectations for US interest rate cuts have seen a sea change since the start of 2024. Confident forecasts of six quarter point cuts have shrunk to fewer than two cuts by year end. Some commentators even predict that rates will be forced to rise again, with options markets pricing a 20% chance of a rate hike. What has caused such a rapid change? We explore the swing in sentiment around the Fed’s intentions. And the broader consequences for financial markets.

Although perhaps slow off the mark in the rate hiking cycle which kicked off in 2022, the US Federal Reserve (Fed) has claimed to be resolutely ‘data dependent’ in recent times. And so far this year, monthly data reports show the US economy to be resilient despite tighter policy rates, with a strong labour market and monthly inflation numbers consistently overshooting forecasts. Fed chair Jay Powell has stated it will likely take “longer than expected” for inflation to return to the central bank’s 2% target, which would then justify interest rate cuts.

Meanwhile, currency markets have embraced the narrative of ‘higher for longer’ US interest rates, resulting in another run up for the mighty US dollar. So much so that the US, Japan and South Korea issued a joint statement highlighting “serious concerns about the yen and the won”. In China, the central bank warned about “one-sided” bets against the renminbi. And the spectre of dollar parity with the euro has again been raised. Why does the rising dollar matter to these economies? The risk is that vital commodity imports, priced in dollars, will again drive up their domestic inflation rates.

What of rate cuts by the other major central banks? The Swiss National Bank surprised markets with a quarter point rate cut in March. But the European Central Bank (ECB) and the Bank of England have maintained restrictive policy rates along with the Fed, although their path to disinflation appears more predictable. Nonetheless, the ECB’s president Christine Lagarde has insisted it is not “Fed-dependent” and has spoken of rate cuts “in reasonably short order”, in the absence of further geopolitical shocks.

Given steadily declining inflation rates in the eurozone, the ECB might yet feel comfortable cutting interest rates as early as June. Whereas, in response to sticky core inflation, forecasts for the earliest cut by the Fed have been pushed back to November. It’s no wonder markets are uncertain. But would the ECB feel bold enough to cut its interest rates before the Fed? The old saying ‘Don’t fight the Fed’ is called to mind, implying that such action could risk spreading volatility beyond the currency markets.