Fed Easing Cycles: Investors’ Initial Expectations Versus Final Outcomes
At-a-glance
- One month prior to Fed easing and tightening cycle, interest rates markets tended to underestimate the amplitude of the moves
- On the eve of the past three recessions, investors initially underestimated the scope of rate cuts by 400-625 bps
- On the eve of soft landings, expectations built into short term interest rate futures curves were often spot on
- As of early September 2024, investors pricing 225-250 bps of rate cuts, more than on the eve of past easing cycles
At its July 31 meeting, the Federal Reserve (Fed) signaled an openness to cutting rates in September, a view reinforced by Fed chair Jerome Powell’s speech in Jackson Hole in August. A subsequent selloff in the equity market triggered by weak US data led fixed-income traders into pricing the Fed easing rates by around 225-250 basis points (bps) over the next two years. (Figure 1). Such expectations can shift quickly. Over the past two years, investor expectations for movement in Fed rates two years ahead have fluctuated from a low of 2.75% to as high as 4.75% (Figure 2).
Figure 1: Fed Funds Futures price 225-250 bps of rate cuts between now and mid-2026
Figure 2: Rate expectations have been choppy over the past two years
Given current market expectations and the Fed’s guidance, we look back over the past four decades to see what investors priced one month prior to the beginning of Fed easing cycles versus how Fed policy actually evolved. This analysis is a follow up to our study from February 2022 where we examined what investors expected before tightening cycles versus how much the Fed hiked subsequently. In that study, we found that from 1994 to 2019, investors initially underestimated the actual amount of tightening by 75-175 bps over four different tightening episodes.
As an addendum, in February 2022, fixed income investors priced the Fed would take rates to around 2.125% by 2024. Instead, by July 2023, the Fed had rates at 5.375%, 325 bps beyond what the market had priced on the eve of the tightening cycle (Figure 3). Could the market currently be underestimating the breadth of Fed easing just as it underestimated the amount of tightening two years ago?
Figure 3: In February 2022, investors underestimated the number of rate hikes by 325 bps
Over the past four decades, the Fed has eased policy seven times. On average, fixed-income markets underestimated the actual number of rate cuts by a wide margin, but there were exceptions, especially around “soft landings” of the economy. In reverse chronological order, here are the market expectations versus reality.
The 2019-2020 Easing Cycle
At the end of June 2019, one month before the Fed lowered rates, markets priced 75 bps of rate cuts by December that year. Indeed, the Fed cut rates from 2.375% to 1.625%, nearly in line with market expectations at the beginning of the rate-cut cycle. The market priced 25 bps of further easing in 2020. In March 2020, the Fed cut rates to zero with the onset of the pandemic, something that nobody could have foreseen in mid-2019 (Figure 4).
Figure 4: In 2019, investors expected Fed easing and were close to the mark until the pandemic set in
The 2007-2008 Easing Cycle
Investors dramatically underpriced the scope of easing that occurred during the global financial crisis. In mid-August 2007, one month before the Fed’s first 25-bps cut, traders priced 100 bps of easing into mid-2008 followed by a gradual tightening. By the end of 2008, the Fed had gone more than 400 bps beyond what the market had priced at the outset, lowering Fed Funds from 5.25% to 0.125%, where it stayed for seven years until December 2015 (Figure 5).