With inflation high and central banks raising interest rates, why are financial markets pricing in rate cuts?

By Gareth Vaughan

Markets and prices for a number of asset classes are currently behaving as they would be expected during a recession, says BNZ rates strategist Nick Smyth.

I speak on the latest episode of interest.co.nz interesting podcast, Smyth also says financial markets are pricing in Federal Reserve rate cuts as early as next year, despite the Fed’s aggressive rate hikes at the moment and US consumer price index (CPI) inflation of more than 9%, suggesting markets are concerned about the… recession risk.

“The market has gained about 90 basis points over the remaining three rate hikes [Fed] meetings this year so the Fed still hiked fairly aggressively for the rest of this year. And then a little over 50 basis points of rate cuts are priced in next year, with the first rate cut fully priced in by June,” Smyth says.

“Why is that?”

“The logical way to interpret this would be to say that markets are concerned about the risk of a recession. And I think you can find evidence of that in different parts of the financial markets,” says Smyth.

“For example, the S&P 500 is down more than 20%. That is the definition of a bear market. Bear markets are often, but let’s not always be clear, associated with a recession. The US yield curve is inverted, which has been the case in the past, a fairly reliable leading indicator of a recession.”

“We have industrial commodity prices like copper, and copper is used for a lot of different things [and] Historically, this has been a pretty good barometer of the strength of global demand. And that was down more than 30% from its peak,” says Smyth.

“So you have a number of asset classes that are behaving as they normally would leading up to or near recessions. And this is happening in the context of central banks raising interest rates really aggressively over a short period of time, quite synchronously.”

Aside from China, which has its challenges with zero-Covid, and Japan, which still has relatively low inflation, Smyth notes that even the European Central Bank is raising rates after not doing so in 10 years.

“So a synchronized global tightening cycle will certainly slow down [economic] Growth. And then we have these other contributing factors that are raising market concerns about the rising risk of recession, including the risk of lockdowns and restrictions in China, and the situation in Europe, where there are potential gas shortages and power rationing later this year.”

“So I think the asset markets are telling you that there is at least a reasonable, if not a high, probability of a recession next year. And historically, during recessions, the Fed has cut interest rates.”

The Fed raised the Federal Funds Rate, its equivalent of the Official Cash Rate (OCR), by 75 basis points to a range of 2.25% to 2.50%. on July 27th. According to Smyth, markets are looking to top out between 3.25% and 3.50% in the current tightening cycle. And they see the OCR, which is currently at 2.5%, with peaks between 3.75% and 4%.

“And the New Zealand market is now reflecting the same profile as the US market, so there are some rate cuts, although not as severe as in the US, which are also priced in at the short end of our curve,” says Smyth.

In the meantime, Smyth says, markets see U.S. CPI inflation, currently running at a “staggeringly high” annualized rate of 9.1%, to about 7.5% by the end of the year, and then to about 7.5% by the end of 2023 2.7% will decrease.

“So that’s a really big drop. And that, in turn, aligns with the market believing there’s going to be a recession or some sort of miracle with global supply chains,” Smyth says.

On the podcast, Smyth also talks at length about this week’s market reaction to the Fed’s rate hike, what the yield curve is telling us right now, quantitative tightening by the Reserve Bank and the Fed, or measures to reduce liquidity or the money supply in the economy. and Expectations for Statistics NZ’s Household Labor Force Survey on Wednesday and what it will say about the labor market.

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