Waiting for the Fed

When will the Federal Reserve begin cutting interest rates? That's the question that has dogged markets for the past few months. Expectations about the timing and magnitude of interest rate cuts have changed dramatically. Earlier this year, the federal funds futures market had priced in as many as six 25-basis-point (0.25%) cuts to the federal funds target rate. Now that number is down to three, implying a year-end federal funds rate of 4.75%. Some are even suggesting that the Fed won't lower interest rates this year at all, due to the strength of the economy and the risk that inflation will remain too high.

One reason for the volatility in expectations is that the Fed has pushed back on the prospect for a rapid pace of rate cuts. Rather, it has indicated that it is "data dependent," watching every data point to assess the next policy move. That leaves investors to react to every economic indicator and extrapolate the results into the future, creating a bumpy road for markets. We still see room for the Federal Reserve to cut by three-quarters of a point this year. , but if inflation continues to come in stronger than expected, the Fed might prefer to hold the rate elevated and cut less than expected.

Two-year Treasury yields have traded in a wide range over the past few weeks on mixed economic data but most recently settled near 4.65%. Because two-year yields tend to correlate with expectations for the federal funds rate one year into the future, the level implies expectations for about 75 to 100 basis points in rate cuts over the next year, which is aligned with our view.

Two-year Treasury yield tends to correlate with expectations for federal funds rate one year in the future

Two year treasury yield

Source: Bloomberg. Data as of 3/11/2024.

Generic United States 2 Year Government Note (GT2 Govt) and US Federal Funds Effective Rate (continuous series) (FEDL01 Index). Past performance is no guarantee of future results.