Precise dates for first rate cuts a ‘red herring’ for bonds
EVERYONE’S guilty of it – but an obsessive guessing game over precise dates for the first central bank interest rate cuts this year seems increasingly pointless to many investors.
On the horizon of a two-year bond or longer, the exact timing of the first cut matters less than the fact rates are now set to fall this year and the extent of that down cycle is the only issue.
After two years of brutal credit tightening, the three main western central banks – the US Federal Reserve (Fed), European Central Bank (ECB) and Bank of England (BOE) – signalled this both this week and last that the top is finally in.
Echoing ECB statements from last week, Fed chair Jerome Powell on Wednesday was pretty clear: “Our policy rate is likely at its peak ... and ... it will likely be appropriate to begin dialling back policy restraint at some point this year.”
In an unusual step, he specifically doused market bets on a March cut but suggested easing was on the table thereafter.
Powell’s Bank of England counterpart Andrew Bailey used different words to say much the same thing – although, by contrast, he pointedly refused to protest at market speculation. “For me, the key question has moved from ‘How restrictive do we need to be?’ to ‘How long do we need to maintain this position for?’”
And so, as it stands, money markets are now fully priced for a first quarter point ECB cut in April, a first Fed move in May and a first BOE move in June.
That deck of dates may well be shuffled many times over the weeks ahead – not least as the seemingly confident official statements mask internal policymaker divisions. BOE rate setters, for example, were split three ways on what to do with rates this week for the first time in 16 years – one vote for a cut, five for standing pat and two for another hike.
The dispersion of Fed policymakers’ rate projections too is estimated to be as wide as it’s been for a decade. And hawks and doves at the ECB slug it out verbally on a daily basis.
To be sure, the starting gun for market speculation on timing the first cuts sounded many months ago.
But now it’s become a day-to-day, hourto-hour obsession. Frenetic trading switches the prime month on futures and swaps back and forth between March, April or May and even out to August as strategists chop and change the rate horizon on each major data point or policymaker pronouncement.
No surprise there – it’s the lifeblood of short-term market trading that’s intent on accurately pricing the precise timing of shifts in cost of money or relative currency values.
And it can matter to the wider economy too to the extent companies or households face refinancing deadlines early this year or imminent debt repayments.
By extension, central bankers, mindful of the lags with which their decisions hit the economy, also care about exact timing as it helps signal relative confidence in sustaining disinflation back to 2% targets – perhaps cooling upcoming wage settlements or helping prevent premature bank lending bursts.
But for investors in longer-term bonds, the top of the rate cycle and the now officially blessed prospect of lower rates ahead makes the timing of the first or second moves somewhat irrelevant.
Far more important is the size and extent of that easing.
And despite Powell’s sideswipe at March bets this week, the full extent of 2024 easing priced into markets actually rose 15 basis points (bps) to 145 bps this week.
“For the longer-term allocator, the risk/ reward of being long the front-end is looking pretty good, based on two quite reasonable assumptions,” TS Lombard’s Skylar Montgomery Koning and Andrea Cicione told clients before this week’s Fed meeting.
“The next move from the Fed will be a cut and 200 bps is a reasonable minimum for cuts this cycle, whether the Fed cuts 150 bps or 75 bps this year.”
Some 200 bps of cuts to 3.37% would still leave Fed policy rates at twice the 20-year average and almost 90 bps above what Fed policymakers see as neutral – and hence still ‘restrictive’ in Fed parlance – and that seems conservative in the scheme of things.
Even so, the TS Lombard strategists reckon that based on a 50-year average premium on two-year US Treasury yields over Fed rates of some 30 bps, then current twoyear yields still at 4.20% offer good value whatever the exact time of the individual cuts.
Morgan Stanley analysts doubled down on that idea and said the March rate cut debate was now a “red herring” for longerterm bond investors.
“We think headlines around the March cut, or timing of the first cut in general, has limited consequences beyond the Fed funds contract pricing for the March meeting,” its macro team told clients, favouring positions in five-year US Treasuries. — Reuters
Far more important is the size and extent of that easing.