In Summary
We continue to expect only one rate cut (-25bps to 3.50%) from the Fed this year. This cut is now expected in June instead of March, which confirms a normalization of monetary policy to neutral settings. A May surprise (-50bps) and resumption of an easing cycle could spook investors. Though investors remain wary of the Fed's increased politicization, they seem reluctant to price in a substantial threat to its independence. Implied rate volatility remains low, market-based inflation expectations are stable at around 2.4% in both the short and long term and institutional checks and balances are considered strong. We expect only one rate cut (25bps to 3.50%) from the Fed this year, pushed back to June from March. While weak hiring remains a top concern for Fed policymakers, the FOMC is divided on the balance of risk between the labor market and inflation. Only accelerating productivity, easing labor costs (-0.5pp over the past year) in the context of the AI rollout and a decrease in tariffs would allow the Fed to cut key rates to 3% this year with inflation cooling faster. An abrupt 50bps rate cut would magnify negative effects on markets. Overall, financial conditions could tighten, with most of the risk concentrated at the long end of the curve. The term premium could rise by up to 50bps, causing a steepening of the yield curve. GDP growth would likely be negatively impacted with a lag, and disorderly movements in the bond market and global spillovers would magnify this impact. Another downside risk is the noise surrounding yield-curve control measures i.e. increase in Treasury demand through regulation or even quantitative easing if long-term yields were to rise.
Recently announced affordability interventions, such as the interest rate cap, the housing policy package and the sectoral intervention require increased scrutiny. These interventions could squeeze credit, interfere with efforts to tame inflation and affect wealth creation from equity markets. First, the one-year cap on credit card interest rates at 10% (down from an average of 25%) will likely counteract the recent increase in credit creation. It will also reduce credit availability for subprime borrowers by cutting the excess spread by nearly 50%. Historically, such caps have proven detrimental to supporting credit expansion and, thus, to the transmission of monetary policy. Second, the purchase USD200bn of mortgage-backed-securities risk pulling forward demand, inflating prices and skewing benefits toward incumbents. On the other hand, the impact of banning large institutional investors from buying single-family homes is likely to be limited, given small institutional ownership relative to the overall stock. Last, the targeted squeeze on sectors that combine high margins, limited competition and shareholder-friendly capital returns, namely defence, consumer finance, pharma and clean energy, could dent wealth effects.