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Rate cuts: Is that what investors really want?

Quick takes on capital markets

May 5, 2023 | 2 min read
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Investors expect that they’ve now seen the last rate hike in this hiking cycle, and for rate cuts to begin as soon as July. However, persistently strong economic data suggests that such a significant pivot in Federal Reserve sentiment is unlikely. For rate cuts to be in the cards, the Fed will need to see a desperately struggling economy or a financial crisis—not a particularly favorable backdrop for investors.

Federal Reserve policy rate
Upper bound, 1990-present

Federal Reserve policy rate, 1990 to Present

Source: Bloomberg, Principal Asset Management. Data as of May 5, 2023.

Following this week’s rate hike, markets are pricing that the Federal Reserve will stop its hiking cycle and have a near-term policy pivot. In fact, Fed fund futures are pricing in a 35% chance of a rate cut in July and are fully pricing in 75 basis points worth of cuts by year-end.

Such a rapid turnaround in policy would be highly unusual. Over the past four hiking cycles, the period between reaching peak Fed funds to lowering rates has ranged from 5 months in the 1994-1995 cycle to 15 months in the 2004-2006 cycle. The latest FOMC statement does not mention a potential easing scenario, suggesting that a significant change in economic conditions is necessary before a pivot is considered.

  • A sharp rise in unemployment: The unemployment rate fell back to a multi-decade low of 3.4% in April. Inflation will stay sticky and elevated as long as the labor market remains tight.
  • Acute financial strains: Despite three bank failures and the KRE regional bank index down over 40% since February, the Fed still considers the U.S. banking system sound. A further sharp escalation of banking strains would likely be necessary to change the Fed’s perspective.

The conditions necessary for the Fed to pivot and cut rates are dismal, requiring a desperately struggling economy or a financial crisis. Investors: be careful what you wish for.

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