By Peter Garnry, Head of Equity Strategy at Saxo
The market’s pricing of the Fed Funds Rate does not square with the economic indicators. It will require a crisis moment to trigger 100 basis points of rate cuts by January.
The US April CPI report yesterday boosted sentiment as traders pushed the forward curve on Fed Funds Futures higher (pricing rate cuts) with the market now pricing rate cuts of 100 basis points by the January FOMC meeting. These expectations do not fit with the economy unless we get a severe economic crisis in the second half. Why is that?
US coincident economic indicators are suggesting the US economy is growing at trend growth. Nominal GDP growth is at 7% y/y and the median wage is up 6.4% compared to a year ago. While the US labour market has softened a bit lately it still remains tighter than before the pandemic started back in 2020. Financial conditions have also recently eased despite the crisis among US regional banks which again suggests that the economy is able to absorb the higher interest rates. Finally, it is important to recognize that while the headline inflation is coming down the core service inflation remains high at 6.3% (see chart below). It is not realistic that the Fed will have sustained inflation around their target until very late this year or early next year. It is because of the factors mentioned above that the forward curve seems disconnected and therefore it must a crisis that triggers the Fed Funds rate cut.
One potential crisis that could trigger significant rate cuts are a drastic cut to US government spending to avoid a default. The US government deficit is currently 8% of nominal GDP and thus a significant driver of the strong nominal GDP growth we are observing. If the US government is forced to rein in spending, then that could be a significant negative impulse. Cutting the deficit from -8% to -4% would correspond to a 3.7% reduction in government spending and thus potentially triggering a harder than expected recession.
But regardless of this apparent disconnect in Fed Funds futures the equity market liked the inflation report pushing equities higher and signaling that the equity market is still not pricing in a hard recession, but instead a small one in real terms while the nominal economy will just continue to grow.
