Investors and analysts, caught off guard, have been forced to abandon their optimistic forecasts of drastic interest rate cuts this year, as rising oil and metal prices add to inflationary pressures, reigniting fears that borrowing costs will have to remain “higher for longer”.
In a dramatic shift in sentiment, markets are now betting that the Federal Reserve will cut interest rates by only a quarter-point or two this year.
That compares with six or more cuts expected in January and three that the more conservative Federal Reserve had projected. But after U.S. inflation this week beat forecasts for the third straight month, traders and fund managers are being forced to carefully review their assumptions.
Optimistic forecasts have “just been thrown out the window,” said Greg Peters, co-chief investment officer at PGIM Fixed Income.
“The markets have been far too optimistic about the prospects for rate cuts,” he added, noting that investors “are now behaving a little more rationally than they were at the start of the year “.
This soul-searching contrasts sharply with December, when the Fed gave its strongest signal yet that it would not raise borrowing costs again and its official so-called “point” projections suggested three-quarter cuts. points this year.
That sparked a rally in stocks and bonds and, after investors braced for a prolonged period of high borrowing costs that could hurt both assets, prompted talk that the notion of “higher for longer » was finally dead.
But a string of bumper jobs data and an acceleration in inflation since then have all but dashed hopes for a rapid easing of monetary policy from the Fed and other global central banks.
“The majority of analysts were wrong-footed,” said Anthony Todd, managing director at quantitative hedge fund firm Aspect Capital, referring to expectations of falling inflation and interest rates.
The firm, which manages about $9.4 billion in assets and whose main fund is up 21.8 percent this year, has benefited from its bets against Treasuries, which have sold off this year so as investors reduced their bets on rate cuts.
Market expectations for rate cuts this year are now even lower than what the Fed itself indicated in December. Some Fed officials have questioned policymakers’ ability to cut rates several times this year, with Atlanta Fed President Raphael Bostic saying it’s even possible that rate cuts could be delayed until next year.
Rising industrial metals and oil prices complicate the inflation outlook – with Brent crude surpassing $92 a barrel for the first time since October.
The overhaul of US rates has also spilled over into European markets, with investors now expecting three cuts for the European Central Bank and two for the Bank of England in 2024, compared to more than six for each at the start. of the year.
“It’s very clear that the narrative is changing,” said Torsten Slok, chief economist at investment firm Apollo. “Uncertainty about where rates will move is why things are so turbulent right now.”
The global economy also proved more resilient than expected, with JPMorgan’s Global Manufacturing Purchasing Managers’ Index moving into growth territory in January for the first time since 2022, and it continued to grow in February and March.
“I still think the Fed wants to cut rates at least once this year, but they are in no rush to do so and will wait for more data to give them more visibility on inflation,” Ken said Shinoda, portfolio manager. director at DoubleLine.
Despite a rally on Friday as tensions in the Middle East pushed investors into safe assets, expectations that rates would remain high for some time sparked a global bond sell-off, driving up government borrowing costs in both sides of the Atlantic. Yields on benchmark U.S. and U.K. government bonds have risen 0.6 percentage points since the start of the year. Equivalent yields on the German Bund – the benchmark for the euro zone – are up 0.3 percentage points.
However, credit spreads – or the premiums paid by corporate borrowers to issue debt securities relative to the U.S. Treasury – are still hovering around multi-year lows, fueled by intense demand for new bonds and inflows of burning funds.
The average spread for U.S. investment-grade bonds is now hovering around its tightest, or lowest, level since September 2021, six months before the Fed began raising interest rates. The high-yield, or junk, bond spread widened following the latest CPI release, but remains near its narrowest levels since January 2022, according to Ice BofA data .
For Pgim’s Peters, “a stronger economy with some inflation is not such a bad backdrop for American businesses.” . . if you forget everything else and focus on the fundamentals, I think the fundamental is pretty good.
So far, the rate overhaul has done little to cool stock markets, with the S&P 500 index of blue-chip stocks up 7.4 percent this year – helped by the strength of the U.S. economy and the enthusiasm generated by the prospects of artificial intelligence.
But some investors have begun warning that as the reality of ever-higher rates sets in, stock market exuberance could run out of steam.
“We feel like we’ve had an easy start, but the landscape is getting tougher,” said Mark Dowding, chief investment officer at RBC BlueBay Asset Management.
Additional reporting by Laurence Fletcher