Investors are betting the Fed will have to cut interest rates next year to support the economy

As the Federal Reserve prepares to meet this week, Wall Street investors are betting officials will aggressively raise interest rates through the end of the year, then turn around and start cutting them in six months.

The unusual bet reflects growing investor sentiment that the Fed is dragging the economy into a recession as it tries to fight inflation, analysts said. At the same time, by limiting longer-term borrowing costs, it makes a recession a little less likely to happen soon. That’s a boost for riskier assets such as stocks, compared to the more traditional bet that rates wouldn’t inflate so quickly.

Bets on the future course of short-term interest rates play a decisive role in determining US government bond yields. These in turn set a floor on borrowing costs across the economy, with higher yields dampening growth and lower yields boosting it.

On the net, investors’ current assumptions about the future do more to fight inflation than hurt it. Their belief that the Fed will continue to raise interest rates this year means that yields are around 3% on Treasuries maturing in a year, even though the real rate controlled by the Fed is currently fixed between 1.5% and 1.75%.

Still, bets that the Fed will start cutting rates quickly by the middle of next year mean that Treasury yields are gradually falling from 1-year to 10-year notes. These traded on Monday afternoon with a yield of 2.818%, up slightly from Friday when it settled at its lowest level since May 27.

Interest rate derivatives, such as overnight index swaps, reveal investors’ thinking in greater detail.

They showed on Friday that investors expected the Fed to raise its benchmark federal funds rate by three-quarters of a percentage point on Wednesday. The Fed is then expected to raise the fed funds rate to around 3.3% by the end of the year. But investors do not expect further increases thereafter. And they’re betting the Fed will cut rates by June, bringing short-term rates down to around 2.5% by mid-2024.

Investors themselves marveled at the sharpness of the anticipated political turn.

“From an expectations perspective, it hasn’t been that extreme,” said Jim Caron, senior portfolio manager and chief global fixed income strategist at Morgan Stanley Investment Management.

The Fed cut rates less than a year after raising them several times in the past, most recently in 2019 when authorities cut rates by a quarter of a percentage point in late July after raising them the previous December. .

Investors, however, have generally been cautious about anticipating such a pivot. In the mid-1990s, when the Fed last tightened policy at a pace close to its current pace, the central bank raised rates a total of 3 percentage points. But investors were ready for it to go much further than that, said Mr. Caron, who was trading at the time.

The Fed, in this episode, last raised rates in February 1995 and then lowered them in July. But it wasn’t until May that short-term Treasury yields suggested investors were bracing for a decline.

Current Treasury yields have mixed implications for investors. So-called inverted yield curves, in which short-term yields are higher than long-term yields, are often seen as a worrying economic signal, having frequently materialized shortly before recessions.

In some ways, however, today’s yield curve only tells investors what they already believe. Betting on rate cuts next year, moreover, serves to lower borrowing costs relative to what they would be if investors didn’t.

For much of this year, rising Treasury yields have depressed stock prices by providing investors with a more attractive safe alternative. Over the past month, however, growing recession fears have depressed long-term yields and equities have stabilized.

Many investors say there are good reasons to bet on a rapid rise and fall in interest rates. In their latest economic projections, Fed officials estimated that rates could climb to around 3.8% next year, but eventually settle around 2.5%.

A look at the markets shows that asset managers are moving money around in a way that suggests they see a recession coming. The WSJ’s Dion Rabouin explains what to look for and why they tell us investors are increasingly pricing in a recession. Illustration: David Croc

As the Fed attempts to rein in growth, investors have detected signs that the economy could slow even faster than expected, such as a sharp decline in housing demand and a lackluster recent consumer spending report. This bolstered their belief that rate cuts could also come sooner than expected by the Fed.

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Many investors, however, are positioning themselves against this consensus. In some cases, investors believe the economy is stronger than commonly believed, indicating strong consumer balance sheets and continuing evidence of a very tight labor market. Others admit that a recession is imminent but believe that inflation, even then, will continue to be high, preventing the Fed from cutting rates.

John Madziyire, senior portfolio manager at Vanguard, said he believed the likelihood of a recession would increase over the next 24 months and therefore favored buying five-year bonds.

Still, he was skeptical that the rate cuts would come as quickly as the market had suggested, in part because the Fed at that time is still likely to reduce holdings of bonds purchased as part of its pandemic stimulus efforts, which could work against the tide. with rate cuts.

“I’d like to think the market is pricing this in, but what actually happens will be completely different,” he added. “That’s how the opportunities start to arise – if you don’t believe in those scenarios, that’s how you start trying to make money.”

Write to Sam Goldfarb at sam.goldfarb@wsj.com

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