Why markets are now pricing in up to three rate cuts by the Fed this year

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Well, the US Federal Reserve has delivered the hint that investors were waiting for, namely that if inflation remains on trend, a September cut is on the table. Joining us now to discuss is Hafiz Noordin, VP and Director of Active Fixed Income Portfolio Management at TD Asset Management. Hafiz thanks so much for joining us, as always.

It's great to be here.

All right. So we have the news from yesterday. We've got a lot of news today about what's happening in the US economy. I feel like the intrigue keeps building and building as to the potential for that September cut. So let's start there. The market was looking for the wink wink, nudge nudge. They got it, it appears.

They absolutely got it. And, certainly, there was no expectation to make any changes to the policy rate yesterday, but looking for that change in the language and the statement and in the press conference. And the reality was that a rate cut in September was already 100% priced in by the market going in.

So the Fed didn't have to do a lot but, essentially, did not push back on that market pricing. And when that happens, that's, essentially, giving the green light to the market to say, you're right. September does make sense. Powell couldn't say that outright, but the shift in the language around the statement definitely got a lot more balanced around the risks to inflation versus the risks to employment. And so, from that perspective, September looks quite likely for that first rate cut.

And as I was saying today, even more information, adding to that intrigue. If we're talking about the risks to employment, which the Fed is willing to acknowledge now, as you said, in those change of language in the statement-- we got jobless claims today. We got some manufacturing information that told us about the labor market. This was not positive news, and the market's not taking it positively.

No. Yeah. And it's very much a true risk-off move in that bond yields have come down to reflect the fact that, to your point, jobless claims higher than expected. That's a very important data point because it's weekly.

It's high frequency. You don't have to wait for those one-month, non-farm payroll numbers. We're going to get that tomorrow. But ahead of that, we've seen a number of different labor market data points starting to weaken. Even in survey data, the quit rate is now below pre-pandemic levels-- so not as much confidence for people trying to leave their job, looking for better prospects.

So, all in all, what that means is now maybe bad news is actually going to mean bad news for equity markets as well. So we're seeing that today. But going back to the Fed, I think they saw this coming. I think it would really take a dramatic shift in the data away from this weakening labor market and weakening inflation to not get that rate cut. And so it looks like the market is really looking to get that going.

Once we get past this week and the jobs data and the Fed behind us, August is considered by some accounts to be a bit of a sleepy month, especially for data before that September meeting. What are the chances that, by the time they hit September, they've seen substantial weakening, perhaps even more than they thought they were going to see?

I think that could happen. And what's really interesting, when we're looking at market pricing for September, like we said before, this week's meeting, 25 basis point cut was already 100% priced in. If we get more weak data like what we're seeing today, we potentially could be seeing a pricing in of a meaningful probability of a 50-bip rate cut.

Now, Chair Powell was asked about this yesterday, because there was a small percentage of that-- call it 5%, 10%. Even today, it's still about 10% chance of a 50-bip rate cut. He was asked about it, and he really pushed back, saying, no, we haven't discussed it. But the market's the market. It's going to price in what it thinks makes sense.

If we see a really weak jobs data tomorrow, there could be many investors thinking, maybe the Fed should have cut this week. So we'll see. The data will dominate. The Fed does always say that they're data dependent, and we'll let that play out.

And by the end of August, we'll have the Jackson Hole meetings. And that's going to be an opportunity for Powell to come back and provide more refined guidance around September.

All right. So September is the market is pricing in fully, a quarter point, whatever we get in September. And if that's the beginning of the rate-cutting cycle, how do you think it plays on after that?

Well, as it stands now with the evolution of some of the data of the past couple of weeks, November and December, the other two meetings for this year for the Fed, also are fully priced in for rate cuts. So right now, the market is expecting three rate cuts at each of the three-- in total, with the three meetings this year.

And then getting into 2025 and '26, another five rate cuts are priced in. So, in total, about eight rate cuts priced in over the next couple of years. So that would take their policy rate from 5.5% to around 3.5%. And so that really goes from that restrictive level to what is right now the market's estimate of neutral going forward.

So meaningful cuts priced in, but I think what could change that is-- are we still in a soft landing regime or could it actually get a little worse than what's expected? I think that's now going to be the debate going forward.

All right. So that's the United States. That's the Federal Reserve, arguably the most influential central bank on the planet. But there are other central banks making news today, including the Bank of England. What are you seeing out there? What's happening?

Yeah, so the Bank of England did also cut as well-- their first cut of the cycle. What was interesting was not so much the rate cut itself but the fact that it was a 5-4 split in terms of the vote. So I think that was interesting in that inflation expectations have been a little bit more sticky in the UK compared to some other developed markets.

So I think it was expected that it wouldn't be a clear-cut case, and that kind of got confirmed by their voting. But, going forward, I think it's still the same broad level trend of softening labor market, softening inflation data.

So Europe, UK, Canada, US are all going in that same direction, just with a bit of timing differences. And I think that's being affirmed from what we're seeing at least from those central banks.

So that's the action we're seeing. What about-- what does it mean for the fixed income market, for the bond market? I mean, investors have been waiting, I think, on the fixed income side for quite some time to see what we're seeing now.

Right. Yeah, it's been a bit of a patient trade, so to speak, in terms of expecting a decline in bond yields. But it's definitely playing out. And it was already starting with the data itself pointing in that direction, where we've seen higher short-end yields, 2-year yields compared to 10-year yields.

We've seen an inversion of the yield curve. We're now seeing that steepening trend come into play, which tends to happen at this part of the economic cycle when we can more comfortably and confidently expect that central banks will be cutting. What's interesting-- and you mentioned other central banks-- is that there's one exception, which is Japan, which this week actually hiked for the second time this cycle.

So rewind to March, they'd only just exited negative interest rate policy. And this week, they did their second rate hike. So we're seeing in some focused markets like that where yields could still maybe go up. But it doesn't look like it's going to derail what would happen in US and Canada.

It's not causing contagion of higher bond yields here in the US and Canada. Here, I think we continue to expect that domestic economic data is driving the bus. And bonds are definitely helping in a diversified portfolio from that perspective. [AUDIO LOGO]

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