Given current market expectations and the Fed’s guidance, we look back over the past four decades to see what investors priced one month prior to the beginning of Fed easing cycles versus how Fed policy actually evolved. This analysis is a follow up to our study from February 2022 where we examined what investors expected before tightening cycles versus how much the Fed hiked subsequently.  In that study, we found that from 1994 to 2019, investors initially underestimated the actual amount of tightening by 75-175 bps over four different tightening episodes.

As an addendum, in February 2022, fixed income investors priced the Fed would take rates to around 2.125% by 2024.  Instead, by July 2023, the Fed had rates at 5.375%, 325 bps beyond what the market had priced on the eve of the tightening cycle (Figure 3).  Could the market currently be underestimating the breadth of Fed easing just as it underestimated the amount of tightening two years ago?

Over the past four decades, the Fed has eased policy seven times. On average, fixed-income markets underestimated the actual number of rate cuts by a wide margin, but there were exceptions, especially around “soft landings” of the economy. In reverse chronological order, here are the market expectations versus reality.

At the end of June 2019, one month before the Fed lowered rates, markets priced 75 bps of rate cuts by December that year. Indeed, the Fed cut rates from 2.375% to 1.625%, nearly in line with market expectations at the beginning of the rate-cut cycle. The market priced 25 bps of further easing in 2020. In March 2020, the Fed cut rates to zero with the onset of the pandemic, something that nobody could have foreseen in mid-2019 (Figure 4).

Investors dramatically underpriced the scope of easing that occurred during the global financial crisis. In mid-August 2007, one month before the Fed’s first 25-bps cut, traders priced 100 bps of easing into mid-2008 followed by a gradual tightening. By the end of 2008, the Fed had gone more than 400 bps beyond what the market had priced at the outset, lowering Fed Funds from 5.25% to 0.125%, where it stayed for seven years until December 2015 (Figure 5).

Similarly, fixed-income investors were caught off guard by the 2001 “tech wreck” recession. In December 2000, one month before the Fed’s first rate cut, investors priced that the Fed would lower rates by about 50 bps from 6.5% to 6% and then eventually raise them back up to 6.25% or 6.5% by 2003. Instead, markets were blindsided by the 2001 recession and an equity bear market that took the S&P 500 down by 50% from peak to trough, while the Nasdaq-100 fell by over 80%. In that context, the Fed lowered rates by 550 bps to 1% (Figure 6).

In the summer of 1998, Russia defaulted on its debt, triggering a widening of credit spreads that in turn sparked a liquidity crisis at over-leveraged major hedge fund Long-Term Capital Management (LTCM). The LTCM meltdown fed a sharp selloff in high-yield bonds and equities and a massive unwinding of the carry trade in the Japanese yen. Between late September and mid-October, the Fed cut rates three times before reversing its policy easing in mid-1999. As of late August 1998, Fed Funds Futures were pricing 25 bps easing but wound up with three times as much in cuts.

After raising rates by 300 bps in 1994 and early 1995, the Fed achieved a soft landing in 1995 and 1996 that allowed for 75 bps of policy easing, something that investors anticipated with near-perfect accuracy one month in advance of the easing cycle (Figure 7).

Between 1986 and early 1989, the Fed raised rates by nearly 400 bps.  By June 1989, the Fed was back in rate-cutting mode.  One month before its policy easing began, fixed income investors priced around 50 bps of policy easing over the coming two to three years.  Instead, with the onset of the 1990-91 recession, the Fed cut by 675 bps (Figure 8), 625 bps more rate cuts than the market anticipated.

Overall, investors were broadly accurate in their anticipations of what the Fed would do during soft landing scenarios like in 1995 and 2019. However, when the economy tipped into a recession as was the case in 1990-91, 2001 and 2008-09, the markets’ initial pricing underestimated the ultimate breadth of policy easing by anywhere from 400 bps to 625 bps.

The market is currently pricing 225-250 bps of cuts.  That’s much more aggressive pricing than we saw in 1989, 2000 or 2007.  As such, if the economy has a hard landing, the ultimate outcome might not miss investor expectations by as much.  However, if the economy has a soft landing, the market could be overestimating the ultimate depth of policy easing.  So, there are risks both ways.

One final point: the 2001 and 2008-09 recessions happened in the context of stable core inflation rates of around 2%.  Currently, core CPI is still rising by over 3% per year (Figure 9).  If inflation persists above the Fed’s target of 2%, this could also limit the Fed’s ability to ease policy.