Benzinga - The consensus outlook for interest rates has shifted dramatically in the last month thanks in large part to the failures of U.S. banks SVB Financial Group, Signature Bank (NASDAQ: SBNY) and Silvergate Capital Corp (NYSE: SI), as well as the emergency takeover of Credit Suisse Group AG (NYSE: CS) by UBS Group AG (NYSE: UBS).
Investors are now anticipating aggressive rate cuts by the Federal Reserve before the end of the year, but Bank of America economist Ethan Harris said Friday that the market is getting it all wrong.
The Numbers: The bond market is pricing in a 74% chance the Fed will cut interest rates by at least 1.25% by the end of 2023, according to CME Group. Just a month ago the market was pricing in just a 0.8% chance of any rate cut at all this year.
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Harris said Friday that since the banking crisis began earlier this month, the market has been pricing in a path forward for interest rates that is consistently below his forecast.
"For example, we see the funds rate at 5.1% at the end of this year compared to 4% priced in the market. Some of this likely reflects flight to safety, but some is likely due to markets putting a high probability on a very adverse outcome," he said.
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What Investors Are Getting Wrong: Harris said one aspect investors may be getting wrong is the Federal Reserve's resolve to get inflation under control. Bank of America's recent Forex and Rates Sentiment Survey found a majority of investors believe the Fed would tolerate inflation above 2% to avoid a recession, while one in five investors surveyed said they believe the Fed would be fine with 3% inflation or higher if it meant no recession.
The Fed would lose a tremendous amount of credibility if it didn't stick to its 2% inflation target, even through a mild recession, the analyst said. In fact, the Fed's latest projection for just 0.4% U.S. GDP growth in 2023 suggests the central bank is at least prepared for the possibility of a recession ahead.
Benzinga's Take: Rate cuts would likely be good news for the SPDR S&P 500 ETF Trust (NYSE: SPY) becuase they would ease pressure on corporate earnings. For better or worse, investors seem to be ignoring the words of the Federal Reserve itself when it says inflation remains enemy No. 1.
"My colleagues and I understand the hardship that high inflation is causing, and we remain strongly committed to bringing inflation back down to our 2% goal," Fed Chair Jerome Powell said this week.
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