The market is pricing in cuts too aggressively but it doesn’t really matter

The market is now pricing in 127 basis points in rate cuts from the Federal Reserve in 2023, with a 12% chance of cuts in January and rising to 71% at the March 20 meeting.

That’s too aggressive based on the data and what the Fed has said already. It’s not impossible for cuts to start in March but we would need to see rapid signs of economic deterioration, starting with Friday’s non-farm payrolls report.

Much of the pricing relies on long-held correlations about how long the Fed can/will stay at peak rates. The last hike was in July and typically the Fed cuts after about six months — or in January. However this cycle has been different in many ways, including a peak of 10% inflation.

In any case, here is why the path of Fed funds doesn’t matter that much and it isn’t what equities, bonds and FX are focused on. It’s all about the regime that we’re in.

Throughout this year, fears have been building that we’re in a regime of high, sticky and volatile inflation. We were pricing in tail risks of a 1970s style situation or some other kind of problematic scenario that was worsened by high fiscal debt.

These fears peaked in late October but since then, the market has signalled a soft landing and virtually every data point globally points to a cooling of inflation. Perhaps prices get stuck at 3% but there is a rising probability that we will return to a 2010s-style regime of low rates and low inflation.

For equities and bonds, that was a good market and for traders, it’s a landscape that they’re familiar with.

There are certainly trades available in the next few months based on mis-pricings in the Fed funds curve but I think the market generally has the right idea in pricing in a return to the 2010s and that trade still has plenty of room to run.

This article was written by Adam Button at Source