Bank of America says markets ‘underestimate’ the Fed’s next moves

Markets are currently pricing in a pause in the Federal Reserve’s interest rate increases next month. A move that will come before the central bank is forecast to cut rates twice before the end of 2023, according to market pricing.

But a new report from rates strategists at Bank of America Global Research out Thursday suggested this pricing means one of two things — either the Fed’s rate hikes aren’t over yet, or cuts will be deeper than markets expect.

“Historically, the market tends to underestimate actual Fed policy ahead of both hiking and cutting cycles: the market often prices too few rate cuts ahead of a cutting cycle and too few hikes ahead of a hiking cycle,” BofA strategists led by Meghan Swiber wrote in a note to clients on Thursday.

Many economists viewed Fed Chair Jay Powell’s press conference on May 3 as indicating a “hawkish pause,” or a lean toward pausing rate hikes while being closer to more hikes than rate cuts.

“Looking ahead, we will take a data-dependent approach in determining the extent to which additional policy firming may be appropriate,” Powell said in prepared remarks during his press conference. Powell added in response to a question about the Fed’s next move: “A decision on a pause was not made today.”

U.S. Federal Reserve Chair Jerome Powell attends a press conference in Washington, D.C., the United States, on May 3, 2023. The U.S. Federal Reserve on Wednesday raised the target range for the federal funds rate by 25 basis points to 5-5.25 percent, saying that the Fed — U.S. Federal Reserve Chair Jerome Powell attends a press conference in Washington, D.C., the United States, on May 3, 2023. (Photo by Liu Jie/Xinhua via Getty Images)

Economic data has largely broken in the Fed’s favor since. Inflation rose at its slowest annual rate in two years in April and the latest jobs report showed evidence of a large enough cooling in the labor market for the Fed to pause future rate hikes, in the view of some economists.

After the release of inflation data on on May 10, markets were pricing in a greater than 95% chance of the Fed pausing in June, according to data from the CME.

But those projections have slowly ticked down as some members of the Federal Open Market Committee — which votes on Fed policy — offer their views on the economy ahead of the Fed’s next policy announcement on June 14.

On Thursday, Dallas Fed President Lorie Logan, a voting member of the FOMC, cast doubt on pausing the Fed’s most aggressive rate hiking campaign in four decades.

“After raising the target range for the federal funds rate at each of the last 10 FOMC meetings, we have made some progress,” Logan told an audience in San Antonio. “The data in coming weeks could yet show that it is appropriate to skip a meeting. As of today, though, we aren’t there yet.”

Investors will closely listen to comments from Powell on Friday when he sits down with former Fed Chair Ben Bernanke at an event in Washington, D.C.

Data from the CME as of Thursday showed chances of a rate hike next month moved up to 36% from 28% following Logan’s comments. Stocks largely appeared unbothered, however, as the tech-heavy Nasdaq rallied more than 1% on Thursday.

“These probabilities have not been right throughout this whole cycle,” Invesco global market strategist Brian Levitt told Yahoo Finance Live on Thursday. “So, it’s possible we could see another rate hike.”

Whether the Fed elects to raise or lower rates in the coming months, however, Bank of America simply notes the magnitude of this move is likely to surprise markets.

“If the Fed does begin a cutting cycle later next year as our economists expect, the Fed may deliver more cuts than what is currently priced one year ahead,” the firm wrote.