ROI-Holdouts against the tide - the case for Fed cuts: McGeever

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Jamie McGeever

ORLANDO, Florida, May 12 (Reuters) - The U.S. interest rate outlook has turned decidedly hawkish since the Iran war started, completely wiping out market expectations for Federal Reserve cuts this year. But not everyone has thrown in the towel.

Before the conflict began on February 28, rates futures markets were pricing in around 50 basis points of easing by year end, partly because President Donald Trump's nominee for Fed Chair, Kevin Warsh, was expected to be more committed to lowering borrowing costs.

But the historic energy shock set off by the war has upended the rates picture. Headline annual inflation is inching near 4% - double the Fed's target - and the Fed is now expected to remain on hold all year. If it does move, it will be to tighten, current pricing shows.

Not only have traders ditched their rate cut bets, but Fed policymakers are dialing them back as well.

The level of dissent at last month's Federal Open Market Committee meeting was the highest since 1992, with three officials objecting to the Fed's accompanying statement signaling an easing bias.

Even Governor Stephen Miran, by far the FOMC's strongest advocate for aggressive and immediate easing, is softening his stance. In December, he was calling for 150 bps of rate cuts this year, according to the "dot plot" in the Fed's Summary of Economic Projections, largely because he felt shelter inflation would cool.

He has since scaled that back to "only" four quarter-point cuts, the March SEP indicated. And last month, he said he may trim that projection further because inflation is still too high.

Many economists have removed their 2026 rate cut calls or pushed them back to next year. Economists at Citi and MUFG are among the few who still think the Fed will be forced to act forcefully this year. Why? Because they believe the economy and labor market are weaker than they appear.

CUT 'EM SOME SLACK

The labor market appears stable, but as Fed Chair Jerome Powell has said, it is an "unusual and uncomfortable" stability, marked by low demand for, and supply of, workers. In the eyes of Citi economists, it is "stable, but fragile," and isn't a source of inflationary pressure.

That's the main reason they are sticking by their now out-of-consensus call for 75 bps of rate cuts this year.

They expect the jobs market to weaken in the coming months, as it tends to do around this time of year. It may already be doing so - the official 4.3% unemployment rate in April was unchanged from March, but that masked a rise of almost a full percentage point to 4.34% from 4.26%. And that was despite a decline in labor force participation.

An unemployment rate above 4.5% would be the highest since 2022, and would likely bring the employment side of the Fed's dual mandate into much sharper focus.

Citi also sees little sign the economy is revving up. Instead, it continues to grow at around 2%, which isn't bad, but around half of that is from AI-related investment. What happens if these bets don't generate the growth, productivity gains and returns everyone is banking on?

"Growth that has slowed to around potential and historically weak hiring is unlikely to produce inflation that the Fed would respond to with higher interest rates," chief U.S. economist Andrew Hollenhorst and his team wrote on Friday.

George Goncalves and his U.S. economics team at MUFG also expect the Fed to ease this year, although they recently trimmed their call to 50 bps from 75 bps. Policy is still "mildly restrictive," they argue, which is tightening conditions for small and medium-sized businesses, housing, and other rate-sensitive sectors. The labor market will soon feel the impact too, they reckon.

Warsh - who has made the case for lower rates - is set to be confirmed as Fed Chair this week. He will probably use his first two FOMC meetings in June and July, and the Jackson Hole symposium in August, to convince his increasingly skeptical colleagues.

That means the window for any easing this year will likely be fairly narrow. But given how rapidly rates expectations have shifted in the past year, don't count it out.

(The opinions expressed here are those of the author, a columnist for Reuters)

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(By Jamie McGeever Editing by Marguerita Choy)