New dot plot highlights disparity between Fed and market outlook

Last Wednesday, the FOMC elected to reduce its target rate by 50 basis points, down to the 4.75–5.00% range. While a growing number of market participants had come to expect the supersized cut over the last few weeks, the decision triggered some surprise in markets, given the lack of explicit foreshadowing by the FOMC. In his press conference after the meeting, Chair Jerome Powell expressed optimism about the prospects of a soft landing in the U.S., with inflation easing closer to the 2.00% target and weakness in labor markets still at a manageable level.

Two-year swap rates fell about 10 basis points in response to the decision, though they later rebounded. Equities rallied on Thursday, with the S&P 500 nearing a 2.00% increase at times intraday. The U.S. dollar was flat through the end of the week, indicating that the weakness introduced by a declining rate environment may be offset by broader optimism about the macroeconomic health of the U.S. economy.

Trends in interest rate hedging

Possibly the most interesting thing to come out of last week’s FOMC meeting was the new Fed dot plot, which shows where FOMC members expect rates to land over the next few years. As you can see, FOMC members are projecting year-end target rates that average to 4.51% for 2024, 3.35% for 2025, and 3.09% for 2026. The market, meanwhile, expects a faster and more aggressive pace of cuts, with the current forward curve falling below the FOMC average, particularly in the next twenty-four months.

For companies with floating-rate debt, the disparity between market expectations and FOMC outlook could make this an opportune time to hedge. Given that the rate attainable on an interest rate swap will price on the forward curve, market participants can currently access swap rates that are significantly below the FOMC’s stated outlook. The dramatic downward slope of the forward curve also means that the expected rate hikes are already priced into swap rates, meaning that companies do not need to wait for the current target rate to decline to attain lower levels.

As an example, the current five-year swap rate for one-month USD-SOFR CME Term is 3.18%, meaning that companies can fix rates at that level today, regardless of whether the Fed’s pace of cuts ultimately lives up to market expectations. Locking in at a swap rate also allows for short-term cash savings in the current environment, as the fixed rate will price well below current rates.

The week ahead

The most anticipated data release of this week will come on Friday, with PCE for August providing the latest on inflation. Consumer confidence, flash PMI readings, and new and pending home sales are also on the docket for the coming days.