Traders are cutting bets on how far central banks could raise interest rates this cycle, reflecting financial markets’ growing fear of an economic slowdown or even a recession.
Data on Thursday showed business activity growth in the United States and the euro zone slowed much more than expected in June, pushing bond yields lower.
Germany has activated the alarm phase of its emergency gas plan amid warnings of a recession if Russian energy supplies are stopped.
And on Wednesday, US Federal Reserve Chairman Jerome Powell said the bank was committed to reining in inflation, even at the risk of slowing growth.
Investment banks have also raised their estimates for the probability of a recession.
As a result, money markets now see US interest rates peaking at around 3.4% next March, down from just over 4% forecast for June 2023 ahead of last Wednesday’s Fed meeting.
Given that interest rates are expected to be around 3.3% in December, the implication is that the Fed will not be able to go much higher next year.
“The terminal rate is falling because people worry that growth will weaken faster than expectedsaid Seema Shah, chief strategist at Principle Global Investors in London.
The Fed raised interest rates by 75 basis points last week after an acceleration in US inflation in May. Their projections showed that the tightening of monetary policy should slow down the economy markedly in the coming months.
“Fed hikes increase recession risk, but that also means the Fed won’t hike as fast as it could, so there’s a circular argumentShah said.
In another sign that recession fears are gripping investors, money markets are indeed anticipating a Fed interest rate cut after March 2023, much sooner than policymakers anticipated.
As for the euro zone, the terminal rate of the European Central Bank (ECB) is around 1.8% in July 2023, compared to 2.6% in September 2023 forecast last Tuesday.
For the Bank of England (BoE), rates are now expected to peak at around 3% next May, up from last Monday’s view that they would hit 3.6% in August 2023.
Bets on lower final interest rates may also reflect the view that lower energy prices will ease price pressures.
Market gauges of inflation expectations have eased, with the US five-year breakeven falling to the lowest level since February, at 2.7%.
While gas prices in Europe have risen, Brent crude futures have fallen nearly 9% since last Monday, perhaps as growth fears begin to overshadow supply limits. Prices are not far off the mid-May lows reached on Wednesday.