Markets Anticipate Rate Cut as Bond Prices Soar

In response to recent market trends, a growing number of investors are expressing their desire for the Federal Reserve to cut interest rates. However, before this wish can be granted, an obstacle must be overcome.

Treasury bond prices have been rising across the board, resulting in a decline in the 10-year yield from its October peak of over 5% to approximately 4.2%. This surge in bond prices suggests that the bond market expects the Fed to lower short-term rates in the first half of 2024. Furthermore, the rate of inflation, which stood at 3.1% year over year in November, has significantly decreased since last year.

As a result, the S&P 500 has experienced significant growth since late October, currently boasting a 21% gain for the year. Investors in the equity market are confident that the economy will continue to flourish given the conclusion of surging rates.

Consequently, companies and households are now benefiting from a decrease in financing costs. Lower Treasury yields have made higher-yielding mortgage and corporate bonds more appealing to investors, leading to a rise in bond prices and a subsequent drop in yields. Notably, the iShares iBoxx $ Investment Grade Corporate Bond Exchange-Traded Fund has seen a nearly 10% increase since its multi-month low in October, while the iShares MBS Exchange-Traded Fund has risen by approximately 7% since a similar level in October.

However, the rise in asset prices poses a predicament for the Fed as it deviates from their desired outcome. While lower yields facilitate access to financing and potentially stimulate consumer spending on goods and services, they may hinder the achievement of the Fed's inflation target of 2%.

Inflation Still a Concern for the Fed

Inflation remains a pressing issue for the Federal Reserve, as evident from the 4% rise in the core consumer prices index (excluding food and energy prices) in November. This signifies a widespread increase in prices across various goods and services. Therefore, the Fed must strive to reduce demand sufficiently to bring down inflation even further.

The Fed is scheduled to make an announcement on Wednesday afternoon. Throughout the second half of this year, the central bank has maintained a balanced stance. It aims to keep interest rates high enough to curb demand while closely monitoring a potentially slowing economy that might necessitate rate cuts. Although it is uncertain what the Fed will reveal, there is a possibility that rates will remain unchanged for some time.

José Torres, a senior economist at Interactive Brokers, emphasized the challenge faced by the Fed. To effectively dampen inflation without triggering a recession, it must maintain its terminal Fed Funds rate for an extended period. Striking this delicate balance is no easy task.

It is important for the markets to remember that the battle against inflation is not yet won. The Fed still has work to do.