UBS strategists see far deeper Fed rate cuts than what markets are pricing

The Federal Reserve will cut interest rates by 275 basis points next year, nearly four times more than what markets are pricing, strategists at UBS Investment Bank predict.

A continued decline in inflation will enable the central bank to start easing policy as soon as March, with rates likely to be cut in the large increments typical of an easing cycle, Arend Kapteyn and Bhanu Baweja forecast. 

“We don’t see the conditions for why this time is so different,” Baweja said in an interview at UBS’s London office. “Inflation is normalizing quickly and by the time we get to March, the Fed will be looking at real rates which are very high.”

The strategists expect the benchmark federal funds rate to fall to between 2.5% and 2.75% by the end of 2024, and see the terminal rate at 1.25% by early 2025. Their view is based on an expectation that the US economy will slide into recession by the second quarter.

In contrast, money-markets are pricing the Fed to cut by just 75 basis points, starting by July.

To support their forecasts, Kapteyn and Baweja point to easing cycles over the last three decades where Group-of-10 central banks, excluding Japan, have tended to cut rates by an average of 320 basis points over a period of 15 months. 

“We think we’re going to have a normal cutting cycle,” Kapteyn said. “Every single central bank — bar Japan — will be easing by a lot more than what markets are pricing.”

Wall Street banks remain divided on the outlook for policy easing. Morgan Stanley anticipates deep cuts, while Goldman Sachs Group Inc. forecasts fewer reductions and a later start. 

UBS also has an out-of-consensus view on the euro zone, predicting it to narrowly dodge recession, which would allow the European Central Bank to delay policy easing. Baweja and Kapteyn expect the ECB to commence its cutting cycle after the Fed — from June — and to cut by only 75 basis points. Money markets, on the other hand, are pricing 100 basis points of easing, starting as soon as April.

While the projected path lower for Fed interest rates is likely to weaken the dollar and push down Treasury yields, Baweja anticipates the 10 year to bottom at 3.5% next year, as volumes of US debt issuance remain elevated.

“In a cycle that is very aggressive in coming down 275 basis points, we see the 10-year only coming down around 100 basis points,” he said.