Investing.com -- The market will likely view the Federal Reserve’s first rate cut in four years as a key signal for future policy expectations, Bank of America (NYSE:BAC) strategists said Tuesday.
More concretely, a 50 basis points (bp) cut could increase the probability of 150bp in cuts by the end of 2024, likely keeping the policy trough in place and supporting further bull steepening of the yield curve.
Oppositely, a 25bp cut might raise the chances of 75-100bp by the end of 2024, potentially leading to some bear flattening of the curve and pushing the terminal rate lower, strategists noted.
“Volatility is likely lower vs recent levels under this scenario also, but higher than in the former given the higher level of uncertainty around the policy trajectory this scenario implies,” strategists wrote in a note.
“Our baseline has been to see volatility drift lower as the Fed starts to ease policy with the underperformance of the left side vs the right side (into flat levels as the easing gains momentum),” strategists wrote in a note. “However, we are more likely to frontload this dynamic in a 50bp vs a 25bp move in September,” they added.
BofA also pointed out that the market may be overestimating risks related to the upcoming election and possibly mispricing the balance of risk in the skew dynamic, which it believes favors a richer receiver versus payer skew.
The bank argues that as confidence around gridlock scenarios increases closer to the election, and with downside risks for the U.S. economy persisting, the market may start to fade election risk. This could lead to “a more directional richening of receiver vs payer skew near term,” BofA’s strategists explained.
They believe the market is also overestimating the likelihood of a hard landing, currently pricing in a 50-55% chance. Strategists argue this is excessive and that a series of 50bp rate cuts doesn’t necessarily indicate recession, especially with current rates above neutral.
A more sophisticated analysis suggests hard-landing probabilities are closer to 30-35%, BofA notes, with the higher end still an overestimate based on current fundamentals. Fading these expectations largely involves tempering aggressive near-term policy easing bets.