Market Traders Pivot Back to Multiple Rate Cuts, Reviving One of the Primary Trading Themes of 2024

At the beginning of 2024, one of the most significant trading themes quickly resurfaced in the minds of investors and traders after a brief period of fading. Initially, financial-market participants began the year anticipating up to six or seven quarter-point rate cuts from the Federal Reserve. However, these expectations dwindled as the months passed. By June, top executives, economists, and traders openly doubted that the U.S. central bank would lower interest rates even once this year, following a surprisingly strong May jobs report showing 272,000 new jobs created.

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This job figure was later revised downward, along with April’s nonfarm payroll gains, earlier this month. This revision prompted a reassessment of whether the highest interest rates in 23 years were finally affecting the labor market. Additional data released over the past week indicated easing inflation based on June’s consumer-price index and a drop in consumer sentiment to an eight-month low in July.

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As of Tuesday, fed-funds futures traders were pricing in a more than 50% chance of three quarter-point rate cuts from the Federal Reserve by December. This would reduce the main policy-rate target to between 4.5% and 4.75% from its current level of 5.25% to 5.5%, according to the CME FedWatch Tool. This marked the third consecutive session with odds above even for such a scenario.

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Furthermore, traders also anticipate a total of five or six rate cuts by next June, which would bring the fed-funds rate target down to either 4%-4.25% or 3.75%-4%. Essentially, they have returned to a similar, multiple rate-cut outlook from January, with the primary difference being the timing of these moves.

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Last week’s stock-market performance provided a glimpse into how rate-cut expectations might fuel a broader rally. On Thursday, when the cooler-than-expected CPI report for June was released, traders began rotating into small caps and other market segments that stand to benefit from lower interest rates. Concurrently, the benchmark 10-year Treasury yield closed at its lowest level since March. The following day, fed-funds futures reflected better-than-even chances of more than two Fed rate cuts by the end of the year.

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A noteworthy equity-market rotation into cyclical and year-to-date laggards occurred last week. Solita Marcelli, the New York-based chief investment officer for the Americas at UBS Global Wealth Management, commented on this rotation, stating, "After such a concentrated move, it’s important for investors to rebalance and remain appropriately allocated." She noted that while UBS is not currently most preferred on small caps, they are historically cheap on a relative basis and could rebound quickly if interest rates fall and growth remains resilient.

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As of Tuesday morning trading in New York, U.S. stocks were mostly higher. The Dow Jones Industrial Average jumped over 500 points after June’s retail sales data came in flat, keeping hopes for a September rate cut alive. Meanwhile, Treasury yields were mixed.

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The resurgence of rate-cut expectations highlights the dynamic nature of financial markets. Initially, the year began with strong hopes for multiple rate cuts, but those hopes waned with robust economic data. However, revised job figures and easing inflation have reignited discussions about potential rate cuts. Market participants are now recalibrating their expectations, considering the possibility that the Federal Reserve might indeed lower rates to support economic growth.

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This recalibration is evident in the recent trading activity. Investors are moving funds into small caps and other sectors that could benefit from lower interest rates. The rotation is driven by the belief that smaller companies, which are often more sensitive to changes in borrowing costs, will see improved profitability and growth prospects if rates decline. The shift in market sentiment underscores the interconnectedness of economic data, monetary policy, and investor behavior.

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The anticipation of rate cuts is also reflected in the bond market, with the 10-year Treasury yield dropping to its lowest level in months. Lower yields indicate that investors are betting on a more accommodative monetary policy in the near future. This sentiment is further reinforced by fed-funds futures, which now suggest a higher probability of multiple rate cuts by year-end.

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While the outlook remains uncertain, the possibility of rate cuts has breathed new life into various market segments. Investors are closely monitoring economic indicators and Federal Reserve communications for clues about future monetary policy. The interplay between economic data and rate expectations will continue to shape market movements in the coming months.

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In summary, the resurgence of rate-cut expectations has led to a significant shift in market sentiment. Revised job figures and easing inflation have renewed hopes for Federal Reserve rate cuts, prompting investors to reposition their portfolios. As the year progresses, the interplay between economic data, monetary policy, and market behavior will be crucial in determining the direction of financial markets.

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