Market Extra: Regional-bank woes have traders briefly seeing up to 50% chance of Fed rate cut in July


Fresh troubles in the U.S. regional-banking sector prompted fed funds futures traders on Thursday to place up to a 50% chance on Federal Reserve policy makers cutting interest rates at their July 25-26 meeting.

Behind the latest worries are concerns about PacWest Bancorp. PACW, -2.99%, which saw its stock price tumble 22% to less than $5 a share on Thursday after the California-based bank reported a 9.5% deposit decline last week.

Earlier in the day, as other regional banks’ shares were also falling, traders briefly priced in a 50% likelihood that Fed officials will cut borrowing costs by at least a quarter of a percentage point in two months’ time. That likelihood dropped to 41.6% by the end of the New York session.

See also: PacWest leads regional-bank stock declines as it reports a deposit drop in early May

Thursday’s developments point to a continuing gulf in expectations between markets and the Fed. Policy makers have been steadfast about the need to bring down inflation, though they provided just enough flexibility in their May 3 policy statement to open the door to a pause from rate hikes in June. Markets, on the other hand, are standing by the view that the Fed will cut rates anyway by December, despite Chairman Jerome Powell’s best efforts to push back against that scenario any time soon.

Read: Why the stock market and the Fed are on ‘two different pages’ after Friday’s jobs report

“The market has been at odds with the Fed for some time now on the topic of rate cuts. The Fed has been as clear as it can be and said it doesn’t see rate cuts, and Powell has gone out of his way to say rate cuts are not in the calculus for this year,” said Michael Reynolds, vice president of investment strategy at Glenmede, which oversees $41 billion in assets from Philadelphia.

“We think we are going to see a 3%-handle on inflation at the end of the year, and even then that’s still pretty hot. The Fed will want to see inflation between 2% and 3% before it’s even thinking of cuts,” Reynolds said via phone. However, “one of the known unknowns right now, and one of the wild cards, is how difficult banking stress can become. If it becomes systemic, the Fed has to keep that in mind. We don’t think that’s the base case and we think the market’s expectations for the probability of rate cuts seem excessive.”

As of Thursday, fed funds futures traders were mostly pricing in a total of three quarter-of-a-percentage-point rate cuts, plus a decent chance of a fourth cut, by year-end. They priced in a 41.6% chance of the first cut occurring in July after accounting for a pause by the Fed in June — which would bring the fed funds rate down to a range of 4.75%-5% versus the current level of 5%-5.25%. Borrowing costs are at their highest level in 16 years after the Fed hiked its policy rate for a 10th straight time on May 3.

Meanwhile, Treasurys rallied as investors flocked to the safety of government debt, pushing yields mostly lower on Thursday. The 2-month T-bill rate led the decline in rates, as traders factored in some likelihood of a resolution on the U.S. debt ceiling. U.S. stocks DJIA, -0.03% SPX, -0.16% COMP, -0.35% ended mostly lower.

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