What The Bond Market Is Telling Us About The Future Path Of Rate Cuts (2024)

The U.S. Federal Reserve is signaling it still sees three rate cuts this year, despite recent hotter-than-expected inflation data. Scott Colbourne, Managing Director and Head of Active Fixed Income at TD Asset Management, looks at the outlook for rates and the implications for the bond market.

Transcript

Greg Bonnell - It's been a big week for central bank action, the US Federal Reserve, for its part, signaling that it still expects three rate cuts this year. So what does it all mean for fixed income? Joining us now to discuss, Scott Colbourne, Managing Director and Head of Active Fixed Income at TD Asset Management. Scott, always great to have you on the show.

Scott Colbourne - Thanks, Greg. Happy to be here.

Greg Bonnell - So we've got a few central banks to get through, but let's start with the big one, obviously. This is the Fed coming out-- obviously, not changing their headline rate as expected, but more of this-- almost like an assurance that what we think is still what they think-- three rate cuts this year.

Scott Colbourne - Yeah. It was a big week. And the Fed gave us, I would say, an accommodative feeling, a mildly bullish feeling for fixed income. They reinforced that the median dot plots for this year is three rate cuts.

So going into the market, as you know, rates had backed up this year - 10-year rates, 2-year rates. They rallied extensively through the end of last year, and they moved up about 40 or 50 basis points across the yield curve in both Canada and the United States. We had better growth numbers. We had hotter-than-expected inflation numbers.

So I think leaning into yesterday's meeting, the markets were running a little hawkish, right? They expected perhaps maybe two cuts this year, an adjustment on the dot plots, and they were surprised. And I think the Fed Governor Powell just said, look, the trajectory on inflation, we're still comfortable where it's going. The trajectory to 2%, it's a bumpy ride. And it was sort of a mixed bag, though, right? They raised the dot plots in 2025 and 2026 and the long run. So there was a little bit of a mixed bag.

But really, the focus of the market was that near-term expectation of what's going to happen this year. So the central thing that the markets have taken away is, broadly speaking, most central banks are looking at cutting sometime in June, first cut. Maybe June, September, and December, out of both Bank of Canada and the Fed this year.

Greg Bonnell - To get those cuts, in the American example because the Fed also had to recognize the US economy has been strong. We're going to lift our GDP forecast. Inflation taking a bit longer to come back down. The labor market's been strong. We've got to change your unemployment forecast, but still delivering cuts. Do they need to start seeing some sign that the US consumer is not falling to pieces, but at least weakening and chilling out a little bit?

Scott Colbourne - Yeah. There's sort of a sense of the -- they're very focused on the labor market. And that is going to be something they're keenly focusing in on, any deterioration on that side. And you're seeing a modest adjustment going on. Today we had the weekly jobless claims and continuing claims. And so there's a modest adjustment to slightly weaker.

I would broadly characterize it post-COVID as a normalization of the US labor market-- not really something to be overly concerned, but the trajectory is slightly weaker. And that's what the Fed is absolutely looking for. It said, look, we can accommodate stronger growth, but we do expect that this disinflationary trend will continue to play out.

They're going to see a lot of data between now and June, right? So they've got three CPI prints and three job prints. So they did start by saying, look, it's very data dependent. It's highly uncertain. Broadly speaking, our confidence is that we're going to go towards 2%. These near-term bumps haven't changed our confidence in that trajectory, maybe just the timing of it. But June is the central tendency now.

Greg Bonnell - Right. That was the message from the Fed. The markets are happy with that message. Let's talk about some of the other central banks. Did you hear anything else from some of the other banks around the world that changed your idea of where we might be headed?

Scott Colbourne - Yeah. We had a -- I would say there was a barbell. We had six developed market central banks this week and seven emerging markets. There were really no surprises out of the emerging markets side. There was a number of cuts out of that side. But I would say on the developed market side, we started with the BOJ this week. And they changed their policy setting. They got out of negative interest rate policy. They moved away from yield curve control. And they started this process of normalization.

That being said, I would have described it as a very soft tightening, if you will. And so that was one side of it. The other side, this morning, we had the first developed market central bank to cut rates. That was a Swiss central bank, softer inflation. They did surprise the market. So we had a bit of the both sides, but I would describe all the central banks - there was the Reserve Bank of Australia, Bank of England, Swiss central bank, RBA, BOJ, Fed- all of them, broadly speaking, I would describe it as slightly dovish.

And on the mildly dovish side, leaning into this sense that, ultimately, the trajectory is to cut sometime this year. And when you look at what's priced in now across the markets, pretty much everybody is sort of penciled in for the first cut in June.

Greg Bonnell - All right. So putting it all together, what does it actually mean for fixed income this year?

Scott Colbourne - You know, then I step back, and I say, look, we've had this huge adjustment upward, 40 to 50 basis points. We're off those high levels. And yes, we had a positive reaction.

Look, it's going to mean that the likely scenario when you look back over rate cutting cycles, whether they're modest or large, leading into that first cut, it's a good time to be in fixed income. There's a range of outcomes, obviously. And I would describe what we're in as more of an adjustment, as opposed to the beginning of a huge rate cutting cycle.

So I'm constructive over the next three months into that first cut, which I think it's hard to bet against. The Fed says June. Okay. I'm not going to bet against it. But we'll watch the data as it comes out. After that point, we'll see. After the first rate cut, we'll see where we go.

Greg Bonnell - I guess the question for investors, no matter what the asset class is, is that we have an expectation. Is it already fully priced into the market, or, as you seem to be suggesting, in the bond market, there's still room to run?

Scott Colbourne - Yeah. We perhaps overshot at the end of last year six cuts, right? So now we're back to three. I think there's room to say, look, if the data cooperates, we'll at least get three, and then we'll see where we go in the new year. And that will mean there is scope for longer term yields to come down and the front-end yields to come down. And that will benefit fixed income investors, for sure.

Greg Bonnell - Yeah. It's a big world. It's a complicated world. There is always risks. We don't know what's around the corner. But if the central banks, for some reason, are -- we'll just take one. We'll take the Fed. What if they didn't cut at all this year? What would have to happen for them say, you know what, 2024 just wasn't the year for it?

Scott Colbourne - Look. Data dependency, the data just continues to turn. That being said, when you step away from the US, the data is consistently showing us that inflation is slowing. Canada, we had CPI on Tuesday, and it definitely caught the market's attention. It was lower than expectation. Today's Bank of England decision, while they kept it on hold, the hawks that were calling for rate hikes, they moved to more of a dovish stance.

So when you step back beyond this exceptional engine that it is the US, the trend is to modest adjustment on growth down and an adjustment on inflation. So it will have to be a surprise on the US side that we don't get any adjustment on inflation. And on balance, right now, the trajectory is there. Be mindful of the fact that the Fed focuses on PCE, rather than CPI, which is everybody's focus. And that is trending softer than CPI at this moment.

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