Bond Traders on Collision Course With Higher-for-longer Mantra

Bond investors and rates traders are increasingly placing bets that interest-rate cuts will commence as early as this summer, challenging the prevailing belief among policymakers that high borrowing costs will persist for the foreseeable future.

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Currently, markets are predicting that the Federal Reserve will implement its first rate cut in June, with a potential total reduction of almost 100 basis points by the end of 2024. Similar expectations for rate cuts are also priced into the European Central Bank, possibly starting as soon as April. In the UK, the Bank of England is anticipated to reduce its benchmark rate by nearly 70 basis points.

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This poses a potential problem for central bankers, who have acknowledged that expectations of tight monetary policy have helped keep bond yields elevated, contributing to cooling the economy.

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Henry Cook, a senior economist at MUFG, suggests that officials will want to resist rate cuts for as long as possible to prevent easing financial conditions. If economic data continues to worsen in the coming months, the central bankers' stance will become increasingly difficult to maintain.

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This pricing trend reflects market skepticism that has emerged since 2021 when central banks assured that inflation would prove temporary. Regardless of whether officials decide to cut rates or not, the decline in bond yields threatens to ease financial conditions, undermining the impact of previous rate hikes.

Christine Lagarde, an Executive Board member of the ECB, has cautioned against discussing rate cuts, deeming it "totally premature."

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Sebastian Vismara, a senior economist at BNY Mellon Investment Management, notes the challenge of preventing the market from becoming too optimistic, stating that as long as there is no credible risk of rate hikes, the market will likely continue to factor in rate cuts.

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Recent data indicating weaker-than-expected payroll numbers and rising unemployment prompted traders to move up their expectations for the first US rate cut to June from July.

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However, there's a risk that this aggressive positioning could backfire, as the market has often prematurely called the end of rate hikes or priced in excessive tightening during this economic cycle. Just as rising bond yields helped policymakers, they are also attentive to signs of financial conditions easing too rapidly.

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In the UK, where inflation is three times the 2% target, Bank of England Governor Andrew Bailey has directly opposed market expectations for rate cuts, emphasizing that it's too soon to consider easing.

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While some strategists argue that the market's pricing is incorrect and investors are rushing into expectations of rate cuts, others believe that central banks are unlikely to implement cuts for at least nine more months, given that inflation remains above target, and there are limited signs of significant economic weakness in the US.

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Overall, the market's belief that policy is excessively restrictive is gaining ground, suggesting that market pressure will persist. Some experts anticipate that, in the future, the ECB will need to implement more rate cuts than currently priced to support the economy.

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In summary, the market is increasingly betting on interest-rate cuts, challenging central banks' beliefs in the need for high borrowing costs, with the timing and extent of these cuts remaining a subject of debate among analysts and traders.

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