What’s the bond market signalling?
The most simplistic approach is to simply look at market-implied Fed Funds for the next 12-18 months. This easy approach shows bond markets are pricing ~175 bps of cuts by early 2025. That’s a lot. And it’s an argument used to say ”the bond market is ahead of itself”.
It’s important to consider two more angles before jumping to quick conclusions. 1) Tight monetary policy becomes even tighter if nominal growth is dropping The US private sector is creating only ~115k new jobs per month on average: that’s not recessionary, but it’s low.
Core PCE is already printing below (!) Fed targets on a 6-month annualized basis. In other words the preferred Fed’s inflation measure is already trending at 2% and the job market is in a typical late-cycle soft patch. In the meantime: Fed Funds are at 5.25%!
So it’s quite obvious the Fed will cut rates in 2024: the question is how quick and how much against what markets are pricing. It will surprise you to know that the option-implied distribution for where Fed Funds will be in December does NOT show that..
6-7 cuts is the base case scenario! This is how the distribution looks like. The modal outcome is rather 2-3 cuts only (!) but the market ”prices 6-7” because the recessionary tail (red) is quite heavy and it drags bond pricing down.
In short: markets are pricing the Fed to deliver only a handful of cuts even as growth and inflation keep dropping – but they incorporate a still robust recessionary tail. The base case outcome is ~3 cuts. The tail-weighted (recession) outcome is ~6-7 cuts.
Tracking market-implied probabilities for several macro scenarios is crucial because it provides you with a better understanding of bond markets and a more actionable market view.