Figure 1: Fed Funds Futures price 225-250 bps of rate cuts between now and mid-2026

Figure 1: Fed Funds Futures price 225-250 bps of rate cuts between now and mid-2026
Source: Bloomberg Professional (FF1...FF24)

Figure 2: Rate expectations have been choppy over the past two years

Figure 2: Rate expectations have been choppy over the past two years
Source: Bloomberg Professional (FZ1...FZ24(, CME Economic Research Calculations

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

Figure 3: In February 2022, investors underestimated the number of rate hikes by 325 bps
Source: Bloomberg Professional: (FFA Comdty 03/10/2022) and FDTRMID

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

Figure 4: In 2019, investors expected Fed easing and were close to the mark until the pandemic set in
Source: Bloomberg Professional: (FFA Comdty 06/28/2019) and FDTRMID

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).

Figure 5: In 2007, investors priced 100 bps of rate cuts and wound up with 512.5bps of easing

Figure 5: In 2007, investors priced 100 bps of rate cuts and wound up with 512.5bps of easing
Source: Bloomberg Professional: (FFA Comdty supplemented with EDA Comdty 08/18/2007) and FDTRMID

2001-2003 Easing Cycle

Figure 6: In late 2000, investors priced 50 bps of Fed cuts and wound up with 11x as much

The 1998 Easing Cycle

The 1995-1996 Easing Cycle

Figure 7: Rates traders were spot on in pricing the mid-1990s soft landing

The 1989-1992 Easing Cycle

Figure 8: Interest rate markets were blindsided by the 1990-91 recession

Figure 9: Core inflation has been coming down but remains above pre-pandemic norms.