Following a historic hiking cycle, the Federal Reserve Open Markets Committee (FOMC) held the target range for its benchmark Federal Funds rate steady at 5.25% to 5.5% for a total of 14 months, longer than many investors anticipated.

Despite the ostensible calm at headline level, rate expectations swung wildly beneath the surface as investors looked to second-guess how economic releases and market ructions would feed into the rate-setting calculus of a ‘data-dependent’ Fed. In January 2024, futures were pricing as many as seven 25 basis point (bps) cuts by year-end; in May, as few as one.

The Fed ultimately began its easing cycle at the 18 September meeting with a large 50 bps cut, an outcome forecasted by only nine of 101 economists polled before the decision.

Stocks, bonds and gold initially rallied on the news, as investors extrapolated 50 bps as the new going clip, but the gains were reversed during Fed Chair Jerome Powell’s press conference. “I do not think that anyone should look at this and say: ‘Oh, this is the new pace,’” he said.

Traders grew skeptical, however, with futures pricing around 75-100 bps worth of cuts across the year’s final two meetings, until a stellar jobs report last Friday showed an economy in good health.

Now just 50 bps worth of cuts are priced in before year end, in line with the latest dot plot. The report has affected expectations further out the curve, too, with traders pricing a Fed Funds rate of around 3.5% in 12 months’ time, up from around 3.0% before Friday.

The Path for Yields

Jayesh Mistry, macro fixed income portfolio manager at BNP Paribas, and Nathan Sweeney, CIO of multi-asset at Marlborough, said that the yield curve will steepen, anticipating a fall in shorter-dated yields as the Fed delivers on the rate cuts expected of it prior to the jobs report.

Mistry argued that longer-dated yields, on the other hand, are likely to rise "as term premia rebuilds and the market eventually prices more growth and reflation risk into the long-end of the yield curve."

Courtney Horey, senior fixed income analyst at Stonehage Fleming, believes futures pricing is broadly fair following the recent adjustment and added the yield curve is biased to steepen.

In his view, there will be a bull steepening of the yield curve, where short-term rates, driven largely by monetary policy, fall faster than long-term rates, which are driven largely by inflation expectations.

Antoine Ternon, multi-asset portfolio manager at APICIL Asset Management, who shares Horey’s view on futures pricing, also expects a steepening dynamic, though of the bear-steepening variety.