Why Wall Street’s Hopes for Big Interest Rate Cuts Have Dimmed, and What’s Next

Investors were once again resetting on Monday after last week’s strong jobs report upended the market’s predictions about how aggressively the Federal Reserve will cut interest rates over the next year. 

The market-implied odds of the Fed not cutting rates at all at its next meeting in November stood at 17% on Monday afternoon. Exactly a week ago, markets saw a 35% chance of a jumbo half-percentage-point cut and a 0% chance of no cut at all.

Investors Contend with Higher-for-Longer Rates

Wall Street has consistently been overly optimistic about the timing and trajectory of interest rate cuts this year. The Fed’s above-average cut last month increased investors’ confidence that policymakers were finally turning dovish. In the days after that cut, investors forecast the Fed would continue cutting rates aggressively—possibly by as much as 1 percentage point—by the end of the year.

Meanwhile, Fed officials forecast cutting rates by half that much, even as the majority projected the unemployment rate would rise to 4.4% in the coming months. At the time, the unemployment rate stood at 4.2% and was trending higher, while the U.S. was consistently adding half as many jobs each month as it did at the beginning of the year. 

Then, Friday’s report showed job creation surged and the unemployment rate declined in September. Previous months’ data was revised upward, implying the labor market wasn’t as weak at the end of the summer as the Fed and economists thought.

The data bolstered the argument that the Fed doesn’t need to rush to the rescue of an economy that’s on track for a soft landing. Chair Powell implied as much last week when he said the Fed was in no rush to cut rates.

Treasury yields climbed on Monday as investors came around to the idea of “higher for longer” interest rates. The 10-year yield climbed above 4% for the first time since early August.

Jobs Report Increases Importance of CPI

Market participants have been shifting their attention from inflation to unemployment in recent months as the former has fallen and the latter has risen. But Friday’s surprising jobs report reminded Wall Street that the road ahead is likely to be bumpy, increasing the importance of this week’s inflation data, argued Bank of America (BofA) analysts in a note on Monday. 

BofA analysts are expecting a slightly firm inflation reading on Thursday, with core CPI forecast to rise 0.3% for a second consecutive month. That, they estimate, would keep the Fed on track to cut rates by a quarter of a percentage point next month. However, surprisingly hot CPI “could make a cut in November less of a sure thing.”

Economists at Oxford Economics forecast core inflation rose a more moderate 0.2% last month. They also expect a quarter-point cut in November.

Traders also saw greater risk heading into Thursday’s inflation report. Options market pricing suggests investors are expecting the S&P 500 to move nearly 110 basis points—or 1.1%—on Thursday after the release of September’s consumer inflation report. That would be the index’s largest CPI-related move since May. 

“While stocks should be able to withstand a slight upside surprise in inflation given improving macro data, a sizable surprise could bring uncertainty on the easing cycle and more volatility into the market,” said BofA analysts.