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Since the beginning of 2024, investors have been primarily focused on when the Federal Reserve will start cutting interest rates.
Initially, March seemed like a good time to do this, but expectations then shifted to June after a wave of unfavorable economic data. Now, for the same reasons, the first rate cut may not happen until December, if at all this year, although UBS economists still expect a rate cut in September.
However, investment prospects actually depend less on when the Fed starts cutting interest rates and more on the path and destination after that, analysts at UBS said.
Analysts noted that the rally is up about 15% year-to-date despite the market price for 2024 cuts falling from about seven to less than two now.
They explained, “What is important is that economic growth and profits were better than expected.” “Whether the first cut is in September or December, it will likely make no material difference to either over the next year.”
“As a result, we expect the debate over the pace, size and end of rate cuts to be at the forefront this summer, a point we made clear in our second-half outlook,” the analysts added.
This reflects the consensus view on macro conditions in the rest of 2024, with most investors expecting moderate GDP growth and inflation, low recession risks, and a realistic range of zero to two rate cuts. However, analysts noted that the range of possible outcomes for growth, inflation, fiscal policy, and Fed rate cuts is much wider for 2025 and beyond.
When focusing on the interest rate path, in particular, the discussion is relevant to investment expectations for three main reasons, the note said.
First, fluctuations in the 10-year Treasury yield closely reflected changes in market expectations of the neutral federal funds rate, suggesting that shifts in expected cuts in federal funds rates could similarly affect the 10-year yield.
Second, the debate over the neutral federal funds rate (r*) and how restrictive current monetary policy should be remains crucial. Opinions vary widely, with some claiming the policy is not too restrictive, while others claim the neutral rate is around 3%.
“The resilience of the US economy favors the first view for now, but a rapid slowdown in growth could push it toward the second,” the analysts wrote.
Finally, the lack of a clear framework from the Fed regarding the path of interest rate cuts is a source of potential market volatility.
While the Fed’s “dot plots” suggest a steady pace of cuts until the federal funds rate reaches 3% to 3.25% by December 2026, it remains uncertain how the Fed will respond to deviations from its growth and inflation forecasts.
As economic conditions evolve, significant fluctuations in expectations of interest rate cuts are likely, which may contribute to market volatility.
