The Stock Market’s Dreams of Rate Cuts Have Been Dashed
Investors had been betting on two or three rate cuts this year. Now, they think they might not get even one.
According to the CME Fedwatch tool, there’s a 74% chance that the fed funds rate hasn’t moved from its current levels of 3.5%-3.75% by the December 2026 meeting. Back in January, investors placed just 5% odds on such an outcome and had accounted for at least a 50% chance they’d get two or three cuts.
The main driver of the shift has been the spike in oil prices. After the initial US and Israeli strikes on Iran’s government leaders and military bases, Iran effectively closed the Strait of Hormuz, disrupting global oil supplies and sending prices skyrocketing.
Brent crude was down on Monday amid signs of de-escalation from Trump, but it’s still up more than 40% since the war began.
The surge has driven up gas prices and fueled fears of a broader inflation spike. When the Fed worries that higher inflation outweighs the risk of labor-market weakness, it tends to take a more hawkish stance, which investors are now pricing in.
Chicago Fed president Austan Goolsbee hinted at this on Monday. He told CNBC that he can envision a scenario in which the central bank hikes interest rates depending on how the Iran conflict plays out and if “inflation was getting out of control.”
That would scramble a key piece of the stock market’s bull case. Investors have been excited about the prospect of rate cuts since the start of last year, as the Fed signaled a more dovish stance amid cooling inflation, and lower rates are a key component of most bullish views from top Wall Street forecasters.
While the fundamental case for no rate cuts has strengthened in recent weeks, Deutsche Bank analysts laid out another reason investors are right to lower their expectations for rate cuts.
In a note to clients on Monday, the bank said the Fed may let recent history inform its decision-making and opt for a hawkish approach to avoid a repeat of the inflation flare-ups of 2021 and 2022.
Deutsche Bank cited the 1979 oil crisis, when the Fed hiked rates more aggressively than it had earlier in the decade, amid rampant inflation. It also pointed to the uber-dovish response to the COVID-19 pandemic after a less accommodative response to the 2008 financial crisis.
“A key lesson from those past crises is that central banks correct for the perceived errors of the last crisis,” Henry Allen, a macro strategist at the bank, wrote in the note. “So as we face another inflation shock, central banks want to avoid the criticisms of 2022 that they’re too relaxed about inflation, and we can see how that’s informing the response today, with more hawkish rhetoric for a given level of inflation.”
At the Federal Open Market Committee’s March meeting last week, Fed Chair Jerome Powell said the committee would be watching for the impacts of the Iran war on inflation data.
“If we don’t see that progress,” on inflation, “you won’t see a rate cut,” he told reporters.
On Monday, President Donald Trump said the US and Iran had “productive” talks about ending the conflict, so interest-rate expectations could shift in the days and weeks ahead.
But, for now, the Strait of Hormuz remains closed, and the odds of a rate cut this year have dwindled.
