Investors warn of ‘disconnect’ as market prices in first Fed rate cut

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Some investors are warning of a mismatch between market expectations and the Federal Reserve’s stated commitment to stamping out inflation as traders stick to their bets on interest rate cuts next year.

Futures traders are betting that the main central bank interest rate will drop to 3.3% by the end of next year after peaking at 3.7% in March 2023. This implies that the Fed will have to cut rates by the second half of next year.

However, some investors say the market misjudges the Fed, which has repeatedly said it is determined to fight inflation even if tighter monetary policy leads to higher unemployment and slower economic growth.

“That, to me, is a gross misvaluation of the market,” said Rebecca Patterson, head of investment strategy at Bridgewater Associates. “Market participants are conditioned by past cycles to expect the Fed to pivot” to a more dovish stance, she added.

The most recent summary of the Fed’s economic projections, known as the “dot plot,” showed that most officials expect the fed funds rate to hit 3.8% by the end of the year. 2023, before falling back to 3.4% in 2024. This June forecast implies that there will be no rate cut next year. A new dot chart will be released next month.

Doubts over the Fed’s commitment to lower inflation have percolated for months as investors wavered in their belief that the central bank will hold on in the face of a downturn.

But the Fed and its officials have stressed they are determined to tackle the highest inflation in nearly four decades. Mary Daly of the San Francisco branch said this week that she was skeptical of the central bank’s rate cut next year.

“The worst thing you can have as a business or as a consumer is that the rates go up and then go down quickly,” she said in an interview with CNN. “It just causes a lot of caution and uncertainty.”

She said it would be wrong to think of a “big hump-shaped rate trajectory, where we go up very quickly this year and then cut back aggressively next year.”

Also this week, St Louis Fed President James Bullard said he backs a third straight rate hike of 0.75 percentage points at the central bank’s next policy meeting in September.

Despite these protests, equity investors are skeptical that the Fed will follow with big interest rate hikes.

When the Fed embarked on an aggressive tightening cycle in March, US stocks fell into bearish territory as investors bet that higher borrowing costs would hurt businesses and consumers.

But the blue-chip S&P 500 and the tech-heavy Nasdaq Composite have since June recouped nearly half of their losses this year.

“There is this disconnect between the market and the Fed, and there is this idea that the Fed is going to have to relax its tightening program to allow for weaker employment and slower growth,” said Gregory Whiteley, manager of portfolio at DoubleLine. “This idea is really strongly entrenched in the markets.”

The rally in equities eased financial conditions, making it easier for companies to borrow and hampering the Fed’s efforts to cool the economy.

A Goldman Sachs index shows financial conditions in the United States have eased significantly since peaking in mid-June after the Fed’s first 0.75 percentage point rate hike.

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