Despite the still hawkish messages from the Fed and the ECB, markets are already pricing in rate cuts later this year. What explains these seemingly premature rate cute expectations? They could reflect differences in views on the economic outlook, but it is unlikely these would be so big to justify current market pricing. Another explanation is that investors are rationally managing their risk exposure. Investors know that an unexpected dovish twist in central bank guidance would cause a rally in bond and equity markets. They also know that central banks have no incentive to already soften their guidance but that they have the option to surprise, like they have done in the past. The closer we get to the terminal rate, the bigger the likelihood that central banks would change their message. For investors, waiting to reposition until the announcement is made would be too late. This causes markets to anticipate rate cuts well ahead of time. It reflects an investor attitude marked by the fear of missing out (FOMO), in this case, the fear of missing the rally. It implies that by the time central banks change guidance, markets will already have priced this in. In the meantime, in case of surprisingly strong economic data, rate cut prospects will be repriced and cause an increase in market volatility.
