Top Line
The long-focal question of when interest rates would fall from their 23-year highs appeared to get a clearer answer on Thursday after better-than-expected inflation data dramatically changed expectations that rates would be cut by the end of the summer.
Traders expect the first rate cut since 2020 to come this summer.
Key Facts
The likelihood that the Federal Reserve will cut interest rates before its September meeting jumped to 89% on Thursday morning, up from 73% on Wednesday and 52% a month ago, according to the CME FedWatch tool, which tracks futures contracts that anticipate changes in central bank policy.
Traders now believe that multiple rate cuts in 2024 are increasingly likely, estimating the probability of two or more cuts at 89% and three or more cuts at 44%.
The shift was reflected in the bond market, where yields on one-, two- and 10-year Treasury notes all fell about 10 basis points to their lowest levels in months. (Lower yields indicate higher bond values.) This suggests bond traders are much more confident that the Fed will have a much easier monetary policy in the coming years.
The stock market reaction to Thursday’s release of inflation data, which showed consumer prices fell month-on-month for the first time since 2020, was much more subdued.
The S&P 500 fell about 0.1%, to a record high, but that was a much more modest move than after previous positive inflation readings, likely reflecting that stock investors are already strongly expecting a rate cut.
But stocks that haven’t capitalized as heavily on the recent AI-driven rally were up big time, with the Russell 2000 index, which tracks smaller U.S. companies, up about 2% by mid-morning, on track for its biggest one-day gain since March.
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Important Quotes
““This is great news on the inflation front,” John Lynch, chief investment officer at Comerica Wealth Management, said in emailed comments. Lynch outlined several ways a rate cut would be “important” for financial markets, including that it would make the federal debt less expensive to service, boosting bond prices and making corporate lending less expensive, lowering the discount rate on future earnings and thus helping to justify higher relative valuations for public companies more broadly.
Main Background
Initially, high inflation prompted the Fed to start raising interest rates in 2022, and the stock market crashed, with the S&P falling 25% in the first nine months of the year. But stocks quickly defied conventional wisdom that rising borrowing costs would cause a prolonged slump, and their relative valuations soared as investors grew more confident in companies’ ability to translate AI and other advances into future benefits. Even if the Fed cuts rates twice this year, lowering the federal funds rate from 5.25% to 5.5% and then again from 4.75% to 5%, interest rates will remain higher than they were in 2007-2022.
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