The yawning gap between market expectations for interest rate cuts at the start of 2024 and now is stark.

From a market implied six quarter of a percentage point rate cuts, expectations going into the Federal Reserve’s latest policy meeting (12 June) have been cut to between one and two cuts before the end of the year.

Two back-to back ‘positive’ surprises on inflation have once again created a widening gap between the Fed and markets, although not to the same extreme as early in the year.

Fed officials held rates steady and revealed a new set of dot-plots spelling out the central bank’s latest summary of economic projections.

They strike a hawkish tone, with core PCE (personal consumer expenditures), the Fed’s preferred measure of inflation expected to tick-up to 2.8% at the end of the year from 2.6% seen in March.

Meanwhile the central bank sees a federal funds rate of 5.1% by the end of the year, implying just one cut, down from three cuts in March. The Fed also moved up its estimate of the neutral rate of interest to 2.8% from 2.6%.

While members of the FOMC (Federal Open Market Committee) appear to have been unmoved by improving inflation data, investors have embraced the better inflation data with both hands.

Bond yields dropped (prices moved up) the most since the end of 2023 with the 10-year treasury yield falling to 4.2%. Interest rate sensitive sectors like the technology-heavy Nasdaq Composite marched to new all-time highs, dragging the benchmark S&P 500 index along for the ride.

Analysts at Morningstar believe the Fed is being too pessimistic and instead see PCE at 2.4% by the end of the year. This is based on PCE inflation annualising at 1.7% in the last six months of 2024.

If this proves correct, Morningstar predicts the first Fed rate cut in September with possibly two more cuts in the offing before 2024 is over. Chief economist Ian Shepherdson at Pantheon Macroeconomics is in the same camp, calling the Fed’s forecasts as ‘unnecessarily aggressive’.

This is fast becoming the consensus view with CME’s FedWatch tool pointing to chances of a September rate cut of 58%, up from less than 50% a month ago. Odds for further rate cuts in November and December have also crept up but remain nothing more than a coin-flip.

The prevailing market narrative has flip-flopped several times over the last few months, so it would be unwise to rule out further surprises before the year is out. 

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