Citi economists took note of several Federal Reserve speakers commenting that the market has overreacted to recent Fed communications, which delivered a massive rally in stocks and bonds.
Despite the FOMC indicating a median of 75 basis points (bp) in cuts for the upcoming year, the market is pricing in a more substantial reduction of around 150bps.
Notably, the impact of Fed rhetoric on market pricing seems limited, especially after remarks from Fed Chair Jerome Powell. Even prior to a notably dovish press conference, where Powell expressed a belief in the potential for inflation to decline without causing significant disruption, the market had already priced in substantial cuts for 2024.
Citi says Powell's focus appears to be on avoiding keeping rates high for an extended period, with the objective of maintaining or potentially extending the already priced-in cuts in the yield curve.
While other Fed officials appear uneasy with the current market pricing, it is suggested that their discomfort may stem from a divergence in expectations. Most officials may not anticipate cuts in March, contrary to the market's pricing of a 25 bp reduction.
“Fed officials have rapidly and aggressively adjusted their rhetoric to ease financial conditions and put near term cuts on the table. Since they are unwilling to significantly tighten financial conditions it will be difficult to get cuts priced out which could ultimately result in earlier cuts being delivered so as not to upend market expectations,” analysts said.
Citi's base case predicts that cuts will commence after March, but the gradual adjustment of market expectations may depend on accumulating data, including stronger core Personal Consumption Expenditures (PCE) for December, and continued signals from officials downplaying the likelihood of March cuts.