【MACRO Alert】Federal Reserve Policy Outlook: The Possibility of a 25 Basis Point Rate Cut and Market

The Federal Reserve's interest rate decisions have always been a focal point for the market. As inflation data is released and the job market evolves, expectations for the Fed's future policies are constantly being adjusted. Recently released inflation data came in higher than expected, leading the market to quickly revise expectations for the magnitude of rate cuts at the Fed's September meeting, suggesting that a smaller rate cut (25 basis points) is more likely, rather than the larger rate cut (50 basis points) previously anticipated.

The bond market's reaction indicates expectations for the Fed to act prudently. Although there was previous speculation that the Fed might cut rates by 50 basis points this month, current market pricing shows that the possibility of a 25 basis point rate cut by the Fed next week has been fully digested. The U.S. Treasury market saw selling after the inflation data was announced, while the S&P 500 rebounded after a turbulent trading day, closing up 1.1%.

George Catrambone, Head of Fixed Income at DWS Americas, noted that both the bond market and the Fed need to see where the economy will land. The biggest puzzle for investors is whether the U.S. economy is entering a soft landing, requiring a series of modest rate cuts like in 2019 and 1995, or if it is heading towards a hard landing at some point next year.

Market expectations for the Fed's rate cuts are also reflected in the changes in the yields of two-year and ten-year U.S. Treasuries. The yield on the two-year Treasury note rose by 9.5 basis points, while the yield on the ten-year note increased by 4 basis points. Matt Eagan, Portfolio Manager at Loomis Sayles, expects the Fed to go through a shorter rate-cutting cycle, ultimately lowering rates to 3.5%, rather than the sub-3% anticipated by the market currently.

The Federal Reserve has kept interest rates in a range of 5.25% to 5.5% since July 2023. As inflationary pressures ease, the restrictive nature of this policy setting is becoming increasingly apparent. Fed officials have been preparing for a new easing cycle that is expected to begin this month, with a rate cut of 25 basis points anticipated at the September meeting. Market tail risks are concentrated on the performance of the economy and the employment sector. Two monthly employment reports will be released before the Fed announces the results of its November 7 meeting, which comes just two days after the U.S. general election. Currently, Fed futures trading reflects that by the Fed's meeting on January 29 next year, the Fed may have cumulatively cut rates by over 140 basis points.

Bloomberg macro strategist Edward Harrison stated that if the Fed next week cannot validate market pricing with the dot plot that predicts future policy rates, yields should rise. The only factor that limits the rise in yields is the hope and dream of future rate cuts of 50 basis points due to the upcoming labor market weakness. The market expects the Fed to cut rates by 100 basis points this year. More of the Fed's thoughts will be revealed after the conclusion of the September 18 FOMC meeting, at which time the Fed will release its Summary of Economic Projections, including its “dot plot,” which depicts policymakers' expectations for the future direction of interest rates.

Eric Wallerstein, Chief Market Strategist at Yardeni Research, believes that the Fed is unlikely to cut rates by more than 25 basis points unless there are recessionary conditions or a financial crisis. He emphasized that a significant rate cut could create volatility in the short-term funding market, a risk the Fed is not willing to take.

The Consumer Price Index (CPI) report shows that core CPI, excluding food and gasoline prices, rose 0.3% month-on-month in August, higher than the expected 0.2%. Michael Pearce, Deputy Chief U.S. Economist at Oxford Economics, pointed out that the negative news on inflation will slightly divert the Fed's focus from the labor market and make officials more likely to adhere to a more prudent easing policy.

Jennifer Lee, Senior Economist at BMO Capital Markets, stated that a 50 basis point rate cut might feel panicky, as if the economy is already lagging. Nicholas Colas, co-founder of DataTrek, analyzed every Fed easing cycle since 1990 and found that out of the five easing cycles during this period, the Fed only began its easing cycle with a 50 basis point rate cut on two occasions, both of which were followed by recessions.

The market's reaction to the Fed's policy will depend on its expectations for economic growth and inflation. If the Fed's rate cut is lower than the market expects and is due to stronger-than-expected growth, then the stock market may have more room to rise. After the latest economic data was released, the market adjusted its expectations for the Fed's rate cut at the upcoming September meeting. Inflation data exceeded market expectations, leading investors to believe that the Fed is more likely to take a smaller rate cut measure rather than the larger rate cut previously anticipated. Currently, the market estimates that there is only a 13% chance that the Fed will cut rates by 50 basis points at next week's meeting, much lower than the 44% a week ago.

Strategists generally believe that a 25 basis point rate cut is the action the Fed is more inclined to take. Eric Wallerstein, Chief Market Strategist at Yardeni Research, stated that unless there is a recession or financial crisis, the Fed is unlikely to cut rates by more than 25 basis points. He warned that a 50 basis point rate cut could create unnecessary volatility in the short-term funding market, a risk the Fed is unwilling to take.

Although recent employment data suggests that the labor market is slowing down, economists generally believe that this is not enough to push the Fed to make a larger rate cut. The market is concerned that if the job market deteriorates significantly, it could signal the beginning of an economic recession. The latest Consumer Price Index (CPI) report shows that core CPI rose 0.3% month-on-month in August, exceeding Wall Street's expected 0.2%. Michael Pearce, Deputy Chief U.S. Economist at Oxford Economics, noted in his report that the rise in inflation could make the Fed more inclined to adopt a more prudent easing policy at next week's meeting, that is, a 25 basis point rate cut.

Some analysts on Wall Street also pointed out that a 50 basis point rate cut could wrongly convey a signal that the health of the U.S. economy is poor. Jennifer Lee, Senior Economist at BMO Capital Markets, stated that a 50 basis point rate cut could trigger panic in the market, giving the impression that the economy is already in trouble. Nicholas Colas, co-founder of DataTrek, analyzed the Fed's rate cut cycles since 1990 and found that the Fed usually does not start its rate cut cycle with a 50 basis point rate cut, an action that usually signals an economic recession. He believes that the Fed is more likely to choose a 25 basis point cut in the first rate cut.