Deutsche Bank Says AI Concerns Compare to "Peso Problem" Current Fed Rate Cut Expectations May Be Irrational

Deutsche Bank says that investors’ expectations for Fed rate cuts may be exaggerated beyond what economic fundamentals justify because the feared artificial intelligence (AI) shock may never materialize.

Strategy analysts including Matthew Raskin wrote in a report on Wednesday that this situation is similar to the classic “peso problem,” where investors price in the risk of a rare, significant event occurring in the future.

The term “peso problem” originated in the 1970s when markets were worried that the Mexican peso might suddenly devalue, leading to a long-term undervaluation of Mexican assets. However, the devaluation did not happen for many years afterward, making the risk premium seem irrational in hindsight. But at the time, investors had to be cautious of potential black swan events.

Deutsche Bank strategists believe that current concerns about AI disrupting the labor market, leading to fewer companies and jobs, are similarly influencing bond traders’ expectations of Fed policy.

Although the Middle East conflict has pushed energy prices higher and caused traders to cut back on bets for rate cuts this year, they still expect monetary easing to continue until 2027.

Raskin said that fears that AI could eventually lead to widespread unemployment may keep these expectations alive, largely unaffected by upcoming economic data.

“In the current environment, whether the market’s expectation that AI will cause a sharp rise in unemployment is correct or not, there is some degree of peso problem involved, and we are completely unsure which short-term data or other factors might lead the market to believe that ‘the risk isn’t as big as everyone perceives right now,’” Raskin and his colleagues wrote. “This means that even if economic data exceeds expectations, expectations for rate cuts over the next year or longer could persist.”