A big disconnect between financial markets and central banks has just deepened further as traders increase their bets on interest rate cuts in the United States and Europe. This comes as evidence mounts that inflationary pressures are rapidly abating.
Money markets are now pricing in over 100 basis points each of rate cuts from the U.S. Federal Reserve and European Central Bank next year. Additionally, the expected timing of their first moves has been pushed forward into the first half of 2024.
Euro zone inflation data for November showed a significant decrease, challenging the European Central Bank’s narrative of stubborn price growth. In the United States, the core PCE price index, the Federal Reserve’s preferred inflation measure, eased in October.
Throughout this year, central banks have successfully pushed back against rate cut bets. However, recent price action suggests that this task could become more challenging as investors question whether the mantra of higher rates for longer can hold in the face of rapidly easing inflation.
Market experts are divided on the future actions of central banks. While some believe that the Fed will begin to cut rates by the end of next year, others argue that there is a possibility the central bank may choose not to cut rates and instead let the ramifications of a recession occur.
Market expectations have shifted significantly in recent weeks, with traders now pricing in a 25 basis point U.S. rate cut in May, up from a 65 percent chance earlier this week. Bets for a March cut have also risen, with traders now pricing in a nearly 50 percent chance.
The shift in expectations creates a challenge for policymakers as the bond and stock rally prompted by the changed expectations loosens the financing conditions they have been trying to tighten through rate hikes.
U.S. Treasury yields have seen the biggest monthly fall in over a decade in November, and a Goldman Sachs U.S. financial conditions index has eased to its loosest level since early September.
While some analysts, like Deutsche Bank, are forecasting even swifter rate cuts than what the markets currently expect, others believe central banks may shift closer to market thinking due to the rapid fall in inflation.
Recent comments from U.S. Federal Reserve policymaker Christopher Waller, who expressed confidence in inflation returning to its 2 percent target, have fueled rate cut bets.
Central banks in Europe are also expected to pivot, with traders fully pricing in a 25 basis point ECB rate cut in April, compared to an expectation of a first cut in July just a few weeks ago.
Thursday’s data showed that euro zone inflation dropped to 2.4 percent in November from 2.9 percent in October, moving closer to the ECB’s 2 percent target.
Experts believe that the recent weak data suggests that euro area monetary policy is too tight and has induced a recession. As a result, they argue that the ECB should begin easing policy as soon as April 2024, with potential for a rate cut as soon as March if there is a further downturn in growth.
The growing divide between financial markets and central banks poses challenges for monetary policymakers. They will need to carefully navigate the evolving global economic landscape and find the right balance to address changing market expectations and maintain economic stability.
