Last month’s dramatic hawkish repricing across the US rates complex found traders fading the odds of Fed cuts in the back half of 2023.

Those “cuts” were a point of contention between markets and policymakers. Fed officials repeatedly insisted that the idea of outright easing by year-end was far-fetched, but the market wasn’t buying it. Not entirely, anyway.

The disparity between speculation on an almost immediate pivot to rate cuts once terminal is achieved and officials’ “higher for longer” narrative was becoming somewhat vexing for the Fed.

Ultimately, the data did the work for them. Robust reads on economic activity eroded rate cut pricing for H2 2023, but as TD’s Priya Misra noted, markets are still pricing nearly 120bps of cuts in the first year after the terminal rate is reached. The market, she said late last week, still “seems to be ignoring” the “higher for longer” message.

The figure on the left is self-explanatory, and the methodology is detailed in the footnote just in case. The table on the right shows market pricing for Fed funds 12 months after terminal during hiking cycles.

Citing the table, Misra suggested “the market has finally learned from history.” That was one of five reasons she listed in arguing that the market is justified in pricing in cuts relatively soon after terminal is reached. Here are those five reasons (abridged, from Misra’s note):

1. The market has finally learned from history. With the benefit of hindsight and the fact that the market is forward-looking, it makes sense that cuts are priced in after the Fed is priced to pause.
2. Since mid-2022, the Fed has been projecting rate cuts in 2024 and 2025. The dot plot has only existed since 2012, but at the time of the end of the last hiking cycle in December 2018, the Fed was projecting 50bps of further hikes in 2019 and 25bps of hikes in 2020. A Fed dot plot implying rate cuts in the near-term gives a green signal to the market to price in cuts.
3. The fast speed at which the Fed hiked rates in 2022 caused a big increase in volatility, which further tightened monetary policy. This can create growth concerns down the road.
4. This hiking cycle also includes QT, which tightens policy through more duration supply and lower reserves. Indeed, in late 2018, financial conditions tightened a lot due to QT and hikes and set the stage for the Fed to cut rates in 2019.
5. The decline in the neutral rate over time would argue for rate cuts even without a recession since a FF rate of 5.5% would be very restrictive (assuming inflation comes down to a 2.5% range).

As regular readers are aware, that latter point is the subject of intense debate currently. It could go either way.

Misra doubts r-star is higher. “We are not convinced about a potential higher nominal neutral rate,” she said, in the same note, adding that, “many of the structural factors which put downward pressure on inflation for many years such as technology, automation or globalization are still present [and] we also don’t believe that r-star has materially increased.”

Underscoring the ambiguity, Deutsche Bank’s Aleksandar Kocic last week wrote that “currently, we do not have a clear indication as to where r-star is and, therefore, what the pace and final destination of rate hikes should be.” He went on to say that “two radically different rates paths could emerge in the short run.”

On one hand, if the neutral rate is higher, the curve would have to acknowledge as much, which at first would mean the belly reflecting a higher terminal rate. On the other hand, Kocic said, the Fed may be “approaching inflation from the perspective of squashing demand,” in which case the odds of a hard landing might be higher now “than the market believed less than a month ago,” in which case the short rate could be “significantly lower” next year, along with risk assets (i.e., in a crash landing).

For her part, Misra thinks the Fed will likely “need to see inflation heading to 2% and an unemployment rate close to 5% before they cut rates,” a situation TD expects to manifest early in 2024, at which point 2s would be “attractive.” Until then, though, uncertainty around terminal (given the prospect of additional strong data) means the front-end could remain perilous. As such, TD is “stay[ing] away” for now, and instead doubling down on a long in 10s. “The Fed is likely to take policy even more restrictive, increasing the odds of a hard landing,” Misra wrote.