The history of the Fed’s rate-cutting cycles in the 21st century teaches a lesson that investors seem to be overlooking. In the Fed’s past currency-lowering cycles, the market has failed to live up to expectations. Investors have repeatedly hoped that the cuts would be less aggressive than they ultimately were, which, if repeated, would prove right analysts who now warn that the Fed is behind the curve and that its rate cuts will end up being deeper than priced in. If this rule of the past is respected again, the bonds will be lower than the consensus estimates of analysts.who believe that 10-year US securities have already absorbed all the rate cuts that the Fed will make during this cycle.
Over the past 35 years, markets have failed to anticipate Fed rate cuts. In the six rate cut cycles since 1990, investors have on average failed in their bets on bond markets. Bonds are the asset used to gauge investors’ expectations for rate cuts, and this time they are pricing in a 250 basis point rate cut over the next 13 months. This is an aggressive move by the Fed, to be sure, but history tells us that the norm is for investors to fail to live up to their expectations.
Alfonso Peccatiello, founder of The Macro Compass, a macroeconomic research consultancy, has pieced together the Federal Reserve’s recent rate-cutting cycles, comparing them to investor expectations before they began. Since 1989, there have been six cycles of currency depreciation in the United States, and in four of them, the reductions anticipated by markets were much smaller than those that were ultimately realized.. In 1990, they were cut by 75 basis points, and the Fed lost 375; in 2000, expectations were for a 210 basis point cut, which ended up being 525; in 2007, 170 basis point cuts were expected, and they were 525, and in 2019, 123 basis points were expected, and they ended up being 225. Only twice, in 1995 and 1998, did markets expect cuts to be larger than they ended up being, but the difference was not as great as in the cycles in which they failed.
These data remind us that markets serve as a guide to the Fed’s future movements, but that mistakes are the most common. This same year, the reversal of expectations for the evolution of rates by the main central banks demonstrates this: at the beginning of the year, investors bought an aggressive cut in rates by the Fed and the ECB for the year 2024, and in the first quarter they gave a twist to this possibility, erasing expectations that this would happen. It was only in the summer, once the first signs of weakness in the American economy were confirmed, with the main indicator being the deterioration in employment figures, that it was confirmed again that the Fed would cut its rates aggressively.
“It is worth remembering the significant changes that have taken place in just one year – who would have thought… it seems more like a decade – in expectations of rate cuts. Let us remember that in September 2023 we were setting cyclical peaks in the debt curves (higher Euribor for example). From there, we went to an overestimation of the cuts… which ended in February, to give way to a much more conservative scenario in terms of monetary flexibility that accelerates the speed of descent,” explains Pedro del Pozo, director of financial investments at Mutualidad.
An aggressive rate cut… but not so aggressive if employment remains scary
Although the rate cuts expected by the market are aggressive, especially in the short term, with two rate cuts of 25 basis points and another of 50 basis points in the three remaining meetings before 2025, the reality is that real interest rates are high, after the fastest hike in over 40 years by the Fed in 2022, and the macroeconomic situation, particularly on the employment front, is showing worrying signs. The Fed has said that its focus is now on employment and no longer on inflation.Unemployment data has become the thermometer that will measure rate cuts in the coming quarters.
In this sense, many analysts warn of the possibility that the Fed will end up lowering rates more than the market expected, since the market may have underestimated the deterioration that could occur in the US labor market and the possibility that the landing of the country’s economy will not be so soft. Ronald Temple, chief market strategist at Lazard, recently revised his expectations for the Fed and “advocates a 50 basis point reduction in September following last week’s US labor market reports,” the manager explains. “This is a change in position from the position he has been defending until now (that there would be no cut of this magnitude at a meeting in 2024) since, in his opinion, the employment data as a whole” suggest that the Fed is once again late, “confirms Lazard.
Similarly, Enguerrand Artaz, manager of La Financière de l’Echiquier, believes that “the American labor market has been showing a gradual deterioration for several months. American employment data remains decisive for the trajectory of the United States and, by extension, for that of the United States.” If the deterioration in employment continues, it is likely that the Fed will have to cut rates more quickly, or more deeply, than previously anticipated.
Peccatiello also believes that it is now clear that the Fed is lagging behind and “playing with fire,” he explains. There is another sign that leads you to be skeptical about the scenario that the market has priced in, and that allows you to conclude that it is likely that bonds are now undervalued relative to the stock market, an asset, the latter, more exposed to declines in the event of a more serious deterioration than expected in the US economy. “Real interest rates [los que descuentan la inflación] have been above 2% for some time, and it is important to look back at past episodes when this happened: in 1999-2000, the Fed kept real rates above 3% for an extended period, and the crisis erupted in 2001. “In 2007, the Fed kept real rates above 2% for a while, and the crisis erupted in 2008. Today, the Fed has been keeping real rates above 2% for some time,” he warns.
Bonds gain appeal if Fed accelerates tapering
If Peccatiello’s scenario is confirmed, it would be logical for bond yields to fall more than the markets are expecting, which would lead investors to obtain higher yields per price. The consensus of analysts gathered by Bloomberg estimates that the American 10-year bond has already gone through this cycle of Fed reductions (the security is currently trading at 3.6%, and estimates indicate that the floor until 2027 will be reached). be at this same level.
However, it should be remembered that this figure is an average, and among the lowest forecasts is that of Steven Major, global head of fixed income strategy at HSBC, an analyst who over the last decade has been credited with getting it right at various times with their bond forecasts contrary to what the consensus thought. “With yields back to levels at the start of the year and a 100 basis point haircut expected before year-end, we remain confident of further bond price action as “We believe that markets have placed too much hope in a soft landing scenario in the United States.”warns, an estimate that matches the one Nicola Mai shared elEconomista.es in recent days. For him, the bond will evolve around 3.3% at the beginning of next year, and will continue to reduce its yield to maturity until closing the year around 3%.
For Peccatiello, this whole situation is attractive from the perspective of a macro-focused investor. “With this approach, you don’t make money simply by being right. It’s a necessary but insufficient condition: you also have to surprise the consensus or, in other words, see something before others see it, position yourself correctly for it, and monetize it when reality converges with your point of view,” the analyst explains. In this sense, positioning contrary to what the analyst consensus predicts is the great hope of debt investors. After all, the market already estimates that the gains by price of US bonds will not be greater.
